Munis in the News: Our Response

SNW Asset Management has been asked by many of our clients to comment on the 60 Minutes news story that aired on December 19th entitled “State Budgets: A Day of Reckoning” and the follow up interview that CNBC aired on December 21st. The story highlighted the growing budget problems that many states and municipalities face, and warned that this could be the next crisis to affect the economy. Featured were Chris Christie, the Governor of New Jersey, and Meredith Whitney, a former bank analyst who now runs her own advisory firm. Numerous municipal bond investors have expressed concern over the comments that Meredith Whitney made in the 60 Minutes story and then in the interview on CNBC. In both interviews she stated that the municipal budget crisis is similar to the bank crisis of 2008. While we appreciate Ms. Whitney’s assertion that many states and municipalities have taken on too much debt, and that these borrowers have used “off balance sheet financing” to continue spending more money than they take in, SNW Asset Management has a significant difference of opinion regarding what this means for investors in municipal bonds. On 60 Minutes , Ms. Whitney stated that there will be a “spate” of “50-100 significant defaults” in 2011 leading to “hundreds of billions of dollars of defaults”. She predicted that defaults will not be experienced at the state level, but on the local city and county level. To see why this is such a bold call, we need to contrast it with what is happening today and what we have seen historically. Currently there is roughly $2.9 trillion in outstanding municipal debt with less than $9 billion in default. This works out to a default rate of less than 0.3%, which is in line with historical averages according to Moody’s. Defaults would have to increase by 11 times recent and historical norms to reach Ms. Whitney’s estimate. Further, it would take a default in 2011 of nearly ALL of the 50-100 largest municipal bond issuers to reach the “hundreds of billions in bond defaults” she mentioned. While we agree that municipal defaults are likely to increase from their historical norms, we believe that the scale will be a fraction of the amount quoted by Ms. Whitney.

Of the rated municipalities that we follow, there are many whose debt-to-asset, tax revenue, and/or pension funding metrics have deteriorated significantly. To say that the number of defaults within the next twelve months will add up to hundreds of billions of dollars is misleading at best. Ms. Whitney states that the transparency of municipal financials is worse than in the banking industry prior to the 2008 financial crisis and that it is extremely difficult to get timely, accurate information on the financial health of a municipality. We would agree that lack of timeliness is an issue but one that is easily avoidable: buy only the debt of issuers who provide timely financial information.

During the CNBC interview, Ms. Whitney states that 2011 will be especially problematic for municipal finances because $140 billion of Federal stimulus funds will end. She also stated that because federal funding equates to roughly 40% of all municipal financing we will see massive cuts and defaults when this money runs out next spring. SNW Asset Management does not dispute that a reduction in federal stimulus money is coming and that there will be a negative impact on state finances, but to say that the funding will lead to massive, imminent defaults is imprudent. Many states and municipalities have been actively preparing for today’s challenges by raising taxes and fees while making deep budget cuts. It is also noteworthy that over the last six months, many state and local governments have reported increased tax revenues year over year from both sales and income taxes.

The most important question moving forward is what should a fixed income investor do? When asked Ms. Whitney stated that investors should sell their municipal bonds now, wait for the “spate” of “significant” defaults to cause municipal bond prices to fall, and then use that opportunity to buy municipal bonds at more attractive yields. Our take is that if an investor were to sell now, he or she would be missing out on attractive taxable-equivalent yields relative to other fixed income sectors.

We also believe that if a major municipality faces a default or restructuring, it may not necessarily lead to a wholesale sell off of the municipal market. Such a scenario could look more like the European debt crisis rather than the bank crisis of 2008. This would mean that a default of Illinois, for example, would drive stronger demand for the debt of fiscally stronger states such as Texas or Washington, because the market will deduce that an Illinois default will not directly affect the finances of other states. This is similar to the debt problems of Greece fueling demand for German debt. The bank crisis of 2008 was different due to the interconnectedness of major global financial institutions. When Lehman Brothers went bankrupt, investors quickly exited the sector for fear of contagion spreading to other large banking institutions. We do not agree with the assumption that these two situations are the same.

SNW Asset Management is very comfortable buying municipal debt today because of our in-depth credit review process and thorough understanding of each security held in our clients’ portfolios. We also continuously monitor our clients’ holdings to track any fundamental changes that may occur. Although we disagree with much that is being said in these as well as other recent news stories, SNW Asset Management is glad to see investors pay attention and ask questions about the credit quality of their investments. Our advice: Understand the credit risk of each security you hold and follow each one closely until maturity. If you do not have the time or skill to do the credit analysis, hire someone who does.

Sell-off Creates Opportunity in Selected Munis

A number of our clients have expressed concern about recent media reporting on municipalities – their budget gaps, revenue shortfalls, unfunded liabilities for pensions and retiree health care, and, occasionally, their preliminary speculation about bankruptcy. These expressions of concern come as SNW Asset Management is in the midst of our re-review of every municipal credit owned by our clients – a total of more than 2,200 items. So far our most recent reviews confirm what we have previously thought, which is that while there are definitely states and local governments with real problems, state revenues (though not expenditures) seem to have bottomed out during fiscal year 2009 and are now showing signs of modest recovery . While there are reasons to fear that states have cut and will continue to cut revenues which they share with local governments into fiscal years 2010 and 2011, we are also finding a great number of credits which, as we had previously thought to be the case, through a combination of planning and foresight and tough decision-making are doing quite well. The trick lies in knowing which credits are vulnerable and which are well-positioned, and we believe that our experience in this market enables us to do this.

Municipal bond prices have been under pressure for more than a month now. There are a number of reasons for this – among others those alarming reports from the media, California’s massive financing, which required relatively higher yields/lower prices to market successfully, and proposals in Congress to reduce the federal subsidy for Build America Bonds or to end the program entirely, which has led to a high volume of quick sales of these bonds with consequent depression of market prices. Many municipal bonds now yield more than comparably-maturing U.S. Treasury securities, even before the effect of their attractive tax treatment is factored in. Given the still-impressive overall credit quality of municipal bonds, the current structure of market pricing represents the best relative buying opportunity in nearly two years.

Near-term, it is certainly possible that the factors which have been depressing municipal bond prices will continue to be at work. It is also certainly possible that depressed prices will continue to spill over from truly weak credits to include even the stronger names which we have acquired (and will continue to acquire) for our clients, but we think that indiscriminate panic pricing of most municipal bonds will prove to be a temporary phenomenon. We are happy to be buyers of municipals at times like this.

In conclusion, recent events in the US fixed income market have caused investors to pay attention and to ask hard questions. SNW Asset Management’s response is that the municipal market, while experiencing some challenges, continues to be an attractive and relatively safe market for investors. We continue to find great value in selected municipals.

Municipal Bonds: Beyond the Headlines

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Municipal bond investors who have been reading the newspapers recently may be wavering between depression and panic.  Articles have described tax and revenue shortfalls, mammoth unfunded pension liabilities, debates about bankruptcy, and any number of specific municipal projects that have gone wrong.  Even Warren Buffett – a legendarily astute and normally upbeat observer – has made some worryingly lugubrious comments about the municipal sector.

At SNW Asset Management, we readily acknowledge that there is no shortage of vexing issues at both local and national levels.  Among them are:

• Continuing decreases in tax receipts, particularly of state income taxes
• Large increases in indebtedness, again largely by the states
• At the municipal level, growing property tax delinquencies
• Again at the municipal level, increasing dependence upon state funding of operations, especially those of school districts
• The weakness of municipal bond insurers and the virtual disappearance of their business, which has removed a potential backstop in case of credit difficulties with specific issuers
• The drag which the slow economic recovery is exerting on municipal finances, which will recover, but likely with a one-to-two-year lag

Many of these are matters that we have discussed in the dozen or so comments we have published on municipal credit matters over the past two and a half years (a complete list may be viewed here).  These are also all matters that we consider in our examination of municipal credits, whether we are reviewing them for the first time for new accounts or systematically monitoring the portfolios of our long-standing clients.  We routinely incorporate levels of indebtedness, cash balances and other revenue resources, stability of on-going financial operations, plans for capital improvements, population and demographic trends, and numerous other factors in our appraisal of municipal credits.  We have not changed either our underlying standards or our methodologies, and we continue to insist on sound credit quality and reasonable maturities for the bonds that we buy and hold in our clients’ accounts.  Hopefully, it will provide some comfort for our clients to understand that, in the course of our recent reviews, we are generally quite pleased with how well the financial operations of the municipal issuers whose debt our clients own have performed.  In particular, we have been very happy with results posted by state university systems, basic municipal utilities, port authorities, and strongly-financed and competitive health care systems.  We have actively increased our exposure to these sectors, because they offer services that the public perceives as vital and values highly as well as a modicum of control over their revenues and pricing.  While we do expect to see some pressure even on very sound municipal credits continuing over the next one to two years, we are happy to report that we see many examples of well-managed municipal credits which are doing very well.  These are the ones that we painstakingly seek for our clients.

Bottom line:  we are not suggesting that you ignore what you read in the newspapers, but we do urge you to look at the details, as we do.  We think that, in many instances, you will be pleasantly surprised by what you see.

Our Thoughts on Municipal Credit Ratings

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For our clients who own municipal bonds, credit issues have been much in the news recently. There have been a number of news items about the credit stresses afflicting many of our states and their municipal subdivisions. A time-honored starting point for municipal credit analysis has been to look at credit ratings published by “nationally-recognized statistical rating organizations (NRSROs),” mainly Moody’s, Standard & Poor’s, and Fitch, but these companies have themselves come under heavy criticism for their failures in appraising collateralized debt obligations and securities backed by sub-prime and low-documented or no-documented mortgages. Perhaps a few words are in order regarding our opinion of the NRSROs and the use we make of their published credit opinions.

At SNW Asset Management, we view credit as the paramount consideration when purchasing municipal securities for our clients. While we feel that the rating agencies have generally done a good job in appraising municipal credits – they got into trouble primarily by venturing away from the types of credit they knew well and understood — SNW Asset Management has always performed independent reviews of every credit we buy, irrespective of their published credit ratings. We reserve the right to disagree with the rating agencies, and we have deemed a number of credits over-rated and others under-rated. For this reason, we urge our clients who own municipal bonds to treat credit ratings as we do — with respect, but not with unthinking respect.

Some of our clients may receive news of rating changes up or down, and where downgrades occur may become concerned. There are four basic reasons why ratings may change: (1) the NRSROs may change their underlying opinion of a credit; (2) they may change their opinion of the insurer of an insured credit; (3) they may change or withdraw ratings when an issue is pre-refunded with U.S. government securities; or (4) they may change their basic rating model of the entire class of municipal credits, such has occurred recently with the publication of new “global ratings” designed to rate municipal and corporate credits on a common basis. The global ratings are a response to criticism that municipal credits rated at given levels were sounder credits and defaulted far less frequently than comparably-rated corporate credits. Moody’s and Fitch have already begun publishing the new global ratings, which have resulted in numerous upgrades for municipal credits, and S & P is expected to follow shortly. Our opinion is that investors should not lose sight of the credit basics. The financial stresses on municipalities are very real, and even as the nation’s economy shows definite signs of the onset of economic recovery, the financial health of our governmental units will improve only with a lag. It may take two years or more for municipal financials to regain the level of vigor they last enjoyed in fiscal year 2007-08. Our advice is therefore to stick to the credit basics like we do, focus on underlying credit quality and ignore insurance, and above all not make too much of changes in published credit ratings, whether for good or for ill. They represent just one useful indicator of credit health. We think our own detailed review of municipalities’ periodic financial statements is far more important.

Challenges Ahead for Public Pensions?

A number of disturbing reports about municipal pension systems have hit the news media recently. In addition to the immediate statistics and investor concerns, we need to consider when in the financial cycle this complex issue occurs. The tenor of most reports is (1) that unfunded actuarial liabilities for state and local government pensions are enormous and growing, (2) that governmental units have been slow to respond, (3) that public pensions tend to be more generous than their private-sector counterparts and that public employees can often game them to the point that payments in retirement can exceed the salaries earned during their working years; and (4) that widespread governmental insolvencies are in the offing unless things change and change quickly. At SNW Asset Management, we routinely look at pension disclosure as part of our credit-review process, and have some thoughts that we would like to share.

“…all of these issues are matters that we at SNW Asset Management considered when selecting municipal credits for our clients’ portfolios.”

First, pension obligations are ongoing and permanent. State and local governments are funding promised pensions for current retirees, for employees who will retire in the future, and even for future employees. Second, pensions represent vested assets that are well protected by law. Outside of bankruptcy, it is extremely difficult for states and local governments to reduce their obligations to pensioners. Third, when evaluating pension liabilities it is also important to view reported obligations within the context of the investment return assumptions that were used. There is some risk that municipalities may use overly optimistic assumptions to value their projected investment results, thereby reducing their pension costs and making it easier to show balanced budgets. In general, investors should look for return assumptions which parallel long-term returns of the asset classes in which plan assets are invested.

Finally, promised payments are to be made over a very long time horizon, which makes it important not to overreact to shorter-term phenomena, even those as traumatic as the two stock market crashes since the year 2000. Estimated obligations are quite large, but estimates can be distorted if you do not take into account when during the financial cycle they were made. Municipal pensions are the subject of recurring actuarial reviews, and these reviews are often completed with a lag time of one or two years or more. Our view is that current numbers being shown are colored by the stock market rout of 2008 – something that is hopefully not the normal state of affairs. We think that projected pension shortfalls will be substantially smaller once the stock market rebound of 2009-10 is factored in. It is true that prudent governmental units must react responsibly to fluctuations in funding ratios, but they must do so with a longer-term perspective. They do need to take timely action to keep current with their actuarial obligations, and they must avoid the temptation to fudge estimates by overestimating investment returns, or underestimating wage and salary inflation. We believe that most governments are reasonable and responsible about their pension obligations. Governments that respond reasonably to their actuarial estimates are likely to be able to manage well in the coming years. Because of the long time-frames that normally govern pensions, even those governments that do not address their problems promptly and prudently are likely not to hit the pension wall for 10-20 years or more. The point here is not to justify inaction or irresponsible action. It is simply to observe that, right now, unfunded pension liabilities – as material as they appear to be – are not as significant to municipal credit analysis as are shortfalls in tax revenues, cuts in shared revenues, and rapidly increasing mandated expenditures. These issues are immediate for municipalities; the pension liabilities are a considerably longer-term concern. However, all of these issues are matters that we at SNW Asset Management considered when selecting municipal credits for our clients’ portfolios.

A large number of state and local governments are taking action to improve their pension positions by moving towards defined contribution plans for new employees, making supplemental payments to their pension funds, eliminating employer pick-ups of employee contributions, and bonding a limited portion of their pension obligations. These actions, singly and in the aggregate, may be in place for some time before their impact becomes evident and material, but this will eventually happen.

Let us consider some additional details to add context and nuance to the more generalized comments that have been offered thus far. The accompanying table sets out comparative pension data for seven states of particular interest to our readers – California, Idaho, Oregon, Washington, Florida, Illinois, and Texas. The first four are the states where most of our clientele resides. Florida and Texas are similar to Washington: large populations, high wealth levels, sizable bond issuance, and no state income tax. We, therefore, routinely buy Florida and Texas bonds to diversify the portfolios of our Washington clients. Illinois is included because it is often mentioned as a state with a serious pension problem.

The table includes data about the latest pension evaluation date, as well as the assumed rate of return on pension plan investments. To forestall an overload of data, we have omitted wage and salary inflation, and length of workforce service assumptions. Key data in the table are the assets and currently estimated actuarial liabilities of the plans, together with the resulting funding deficits or (in the case of Florida) surpluses. The table adds explanatory detail by calculating the funding ratio (which simply divides assets by liabilities), the per capita unfunded pension liability (unfunded liabilities divided by population), and the unfunded liabilities as a percentage of aggregate personal income in each state. All the data in the table are based on the largest pension plans in each state – normally, the public employees’ retirement plan plus the teachers’ retirement plan. The exception is Florida, the data for which also include the plan for retirement health care benefits, which, though small at present, still shows a large unfunded liability. What is impressive about Florida is that the basic retirement plan, taken strictly by itself, was overfunded by $6.6 billion as of mid-2008.

The results reported in the table highlight a number of interesting points. Some states, such as Texas and Washington, are clearly in systemically better shape than others. States with large populations and high income and wealth levels stand to do better than smaller, less diversified and wealthy jurisdictions. In some states, such as California, unfunded pension liabilities are considerably less than the state’s outstanding bonded debt. Other states are less well positioned, for example Oregon and Illinois. Even here, though, the reader must be very careful with these numbers. Earlier portions of this comment noted the critical importance of when in the economic cycle pension numbers are analyzed. In fact, from year to year the numbers can be surprisingly volatile, which reinforces the idea of examining comparative pension data over a number of years rather than simply taking a “snapshot.” Consider Oregon, which as of mid-2008 showed a funding ratio of 71% and rather high levels of liability versus population and personal income. Yet, only one year earlier – in mid-2007 – Oregon’s funding ratio was 98%, and the other numbers were much, much smaller. Investors who are concerned about pension liabilities should therefore take care to look at the numbers over a long period – no less than 5 years – and avoid jumping to too-pessimistic conclusions right now, when we are still near the bottom of the financial cycle.

The bottom line for investors is that pension liabilities should be analyzed with a long-term perspective and with attention to the details of each municipality’s program and invest accordingly.

SNW Asset Management Investment Committee