Fixed Income War Story #2

Perhaps one of the most remarkable episodes in bond market history was recounted in the report shown above, written by Joe Mysak, Bloomberg's venerable Municipal Bond expert and columnist. I had not read the report since I picked up a copy of it at a visit to Bloomberg headquarters in New York City to attend a conference some years ago, but it is remarkable tale that shows how nothing really changes.

The hubris of certain media personalities and the ability of the media to whip up hysteria, like fire on ice, remains embedded in the market narratives we hear today. The sober voices are drowned out.

In the aftermath of the 2008 financial collapse, people were understandably nervous about the state of the economy. And given that revenues to every level of government shrank dramatically in the face of the Great Recession, the germ of an idea that governments would not be able to service their obligations began to form. The first area of concern was pension funding, and there was, and remain today, some bad state actors in this area. However, they have managed to keep themselves stitched together through a combination of steps to lower their funding burdens. The worst actors always manage to do the bare minimum, but they do survive.

But the drumbeat of the possibility of defaults wouldn't stop, and the prospect of the Federal government bailing out states was on the table. The reasoning was that if they bailed out General Motors, how could they turn down public entities? But they needn't have worried. In the meantime, some characters who are still on financial media today, blasted out stories like "The Top Ten Cities That Are Not Coming Back" (sound familiar?) or that California would go bankrupt and its muni bondholders would face a bloodbath. They still have huge followings today, and make many appearances on TV and radio. It is interesting how some people pay a price for their bad calls, and others remain unscathed.

Now you have to appreciate the background that existed here. No one trusted the ratings agencies anymore since they whiffed the mortgage meltdown with their dubious "analysis," and the mood of the country was incredibly sour.

There was a lot of fearmongering, all of it false, by certain actors at think tanks who had a predictable contempt for anything that was related to government funding. These scribes are still at it today, comfortable in their 501(c)3 funded sinecures, churning out the bile.

This set the stage for a banking analyst with no knowledge of the municipal market, to make a wildly reckless call on one of the most watched news programs in the country: 60 Minutes. On December 19th, 2010, an analyst at Oppenheimer by the name of Meredith Whitney who had, to her credit, accurately predicted in late 2007 that the banking sector would face a terrible reckoning, was now making a prediction on the municipal bond market.

Then as now, when market calls prove timely and correct, the analyst is showered with attention, praise and notoriety. Bloomberg crowned her "The Oracle of Wall Street." Accolades from Fortune Magazine, CNBC and other outlets proclaimed her wisdom. All it takes is that one call when an analyst can see around corners, and they are whisked onto the throne.

Mysak, however, was quick to correct her prediction.

The 60 Minutes appearance had an explosive effect on the market, which is still hard for me to grasp. Municipal bonds aren't a big sell at retail wirehouses, mostly because there isn't much money in selling them, and to the dismay of the commissioned broker, most people don't trade out of them. It's still a specialized corner of the market and it takes some specific knowledge and expertise to exploit it to the client's advantage. Prior to this, it was "a period of splendid isolation," as Mysak described it.

But in the days when marginal tax rates were higher, and with the safety of state and local debt backed by the unlimited taxing power of municipalities, many older, conservative or retired individuals had stocked their portfolios with them for years. And Ms. Whitney did one hell of a job scaring the daylights out of them and triggering an avalanche of selling, depressing prices.

What is still remarkable to me today is how the retail investor bought into the fear. There were stories of investment advisors begging their clients not to liquidate their portfolios, especially with the Fed Funds Rate then sitting at 0.18% in the aftermath of the 2008 calamity. The returns couldn't be duplicated anywhere, especially with such favorable tax treatment.

Muni professionals couldn't believe their luck. The retail market was convulsed with selling, while the market veterans who knew full well Ms. Whitney didn't know what she was talking about gleefully picked up high quality paper at fantastic discounts. "The Great Muni Bond Turkey Shoot" was on, and if you knew the market, you were rewarded with tax free yield opportunities we wouldn't see for a long time once everyone realized that nothing of the kind that Ms. Whitney predicted was ever going to happen.

For one thing, as Mysak noted, the top 50 to 100 entities in municipal debt didn't even HAVE "hundreds of billions" of issuance to default with. Steve Croft, who interviewed her, was ill equipped to challenge her predictions and simply let her speak.

A few seasoned hands, like Tom Kozlik, Matt Fabian and Dick Larkin, who had a deeper understanding of the muni market issued some reasoned analysis as to why the defaults wouldn't occur, but unfortunately, those aren't the people who get the air time on a national network. Besides, the damage was done.

Larkin was one of the most vocal:

“When I saw 60 Minutes I was spitting mad. To predict hundreds of billions of defaults of municipal bonds would be to make an assumption we are going to have something worse than the Great Depression of the 1930’s. Her prediction is ludicrous. I think it’s irresponsible. It’s damaging a lot of peoples portfolios. I know cities and states are having problems but I have seen them perform through six recessions and this recession is clearly the strongest and the worst since the Great Depression and yet I don’t believe there are going to be wholesale defaults.”

Larkin was right about that, but his call, years later, on the low possibility of default for Puerto Rico bondholders would prove to be costly. He maintained that position as the Island's financial picture became ever more precarious. It would hurt his reputation after an accomplished career in the credit markets.

Whitney faded away into obscurity as far as the markets were concerned. Some market observers who had agreed with her didn't miss a beat as far as their careers went. Some relatively obscure analysts who work in government who thought as Whitney did suffered no loss of reputation or even mild reproach.

There are a lot of lessons to be learned from this episode. And unfortunately, they never will be learned.