Chanos says dump munis as distress mounts and ratings attacked

I have really started to dislike municipal bonds as an asset class. They have seen a huge rally along with almost every other financial asset but the underlying fundamentals are weak because of financial distress at states and municipalities.

Last week, I wrote a first piece on this topic, based on some work by Philip Greenspun and Fred Sheehan. I also just wrote a piece about Ambac Financial’s likely bankruptcy, which will impact this market because of Ambac’s municipal bond guarantees. But, a Barron’s piece about Jim Chanos of Kynikos called “Short Seller: Dump Munis” piqued my interest and precipitated this particular article.

Chanos is bearish

The Barron’s piece by Tom Sullivan said:

James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market — in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron’s staffer Susan Witty, adding that he wouldn’t touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It’s not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It’s all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state’s bonds will likely lose their federal tax exemption, he adds.

Sullivan went on to use New York and New Jersey as other examples of what is amiss for state bonds.

Revenue shortfalls

A New York Times article which I linked to this morning makes the situation in New York plain, ending with this:

The comptroller’s office numbers are more pessimistic than those from Mr. Paterson’s budget office. They project that the deficit for the remainder of the current fiscal year stands at $4.1 billion, with deficits of $7.8 billion and $15.7 billion in the succeeding years.

Mr. Ravitch, who helped steer New York City through its financial crisis in the 1970s, said, “The numbers are real and my own personal view is that they’re going to get worse.”

New York and New Jersey are suffering the same problems that California suffered, namely a huge fall in income and property tax revenue. This is true all over the country in places as far apart as Oklahoma, Hawaii, Texas, and Georgia.

Assets falling, liabilities ballooning

But, it’s not just about revenues versus outlays – the income statement. It’s also about assets and liabilities – the balance sheet. recently I spoke to Peter Schweich, a retired vice president of Boston University and founder of Boston University Academy, who had done some research on municipalities in Massachusetts and he explained that his research indicated that municipalities had seen a 30% fall in investment portfolio values during the credit crisis (much obviously gained back since). Even worse, he pointed me to enormous looming liabilities not reflected on balance sheet or considered by the ratings agencies.  In a recent Forbes article, he wrote:

While municipalities are able to raise property taxes to cover current salaries, not without considerable pain to the taxpayer, few of them, if any, are prepared for the future financial demands of their grossly underfunded or completely unfunded Other Post Employment Benefits (OPEB) obligation. OPEB obligations are primarily associated with health benefits for retirees.

In 2006, the Federal Reserve Bank of Chicago held a pension conference. In a short note, it reported that a "back of the envelope guess" for OPEB was $700 billion and that "other estimates suggest that OPEB exposure could range from five to 10 times current outlays for retiree health care."…

Cambridge, Mass., now known to most Americans as the city where a homeowner can be arrested for "breaking into" his own home, serves as a good example of the overwhelming burden residential and business property owners across the country are about to confront. Current and future Cambridge residents are now facing a completely unfunded OPEB obligation of $602 million. That figure, alone, is nearly one-and-a-half half times greater than the city’s entire 2009 budget. In addition, like most municipalities, the recent economic downturn has resulted in a significant loss to Cambridge’s regular pension fund: a 28.6% loss in 2008 in the amount of $225 million.

In addition, Cambridge has an unfunded liability for its regular pension fund (distinct from the OPEB fund) to the tune of nearly $70 million, and, of course, Cambridge also carries bond obligations, as do many municipalities. The Cambridge bond obligation exceeds $300 million. This means Cambridge, with approximately 75,000 permanent non-university student residents, one municipal employee for every 22 residents, and 22,000 taxable parcels, has current financial liabilities of nearly $1.2 billion…

Not surprisingly, the Cambridge city manager boasts of Cambridge’s financial stability each year in the introductory letter to his submitted budget. To bolster his claim, he proudly points to the Triple A bond ratings that Cambridge holds from Moody‘s, Fitch and S&P. Cambridge, therefore, has 75,000 residents, 22,000 taxable parcels, $1.2 billion in financial liabilities–and a Triple A bond rating from Moody’s, S&P and Fitch.

These are circumstances that are being repeated across the United States. Expect scandals involving alleged improprieties to mount when financial distress hits. One notable example in the news is San Diego, where the top pension administrator is exiting after last year’s over 25% loss and where the fund is also being buffeted by two separate scandals: a conflict of interest scandal and a scandal where overtime pay was counted toward the formula in firefighters’ pension overtime. San Diego was also in the news a few years back because of a separate scandal where an alleged special pension benefit for the fire chief was under attack. See also San Diego’s Pension Scandal for Dummies from 2005, which details the conflict of interest case to that date.

Ratings agency problems

Then there are the rating agencies. Remember the whistleblower scandal from last month? It was all about municipal bonds and the Moody’s allegedly putting their revenue generating relationship with municipalities ahead of the rating function. If you recall, it was exactly this conflict of interest which led to Arthur Andersen’s downfall in the Enron scandal.

This is what Reuters said about the Moody’s whisteblower scandal last month:

Two former Moody’s executives — Scott McCleskey and Eric Kolchinsky — testified that senior managers were willing to silence employees who raised concerns about the ratings process or compliance efforts.

McCleskey said that while he was the head of compliance at Moody’s, he voiced concerns that the firm was not properly monitoring ratings on municipal debt. McCleskey, who was dismissed by Moody’s in 2008, said he was instructed not to mention the issue in e-mails or writing.

Kolchinsky, a Moody’s managing director who was recently suspended by the firm, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

The two whistleblowers were flanked by Moody’s current chief credit officer, Richard Cantor. Cantor sat impassively, staring straight ahead as his former colleagues described their concerns to the lawmakers.

In his testimony, Cantor said Moody’s had recently hired an independent law firm to review Kolchinsky’s allegations.

That was criticized as an empty gesture by Chairman Towns, who said the law firm had no deadline and would not produce a written report.

Kolchinsky told lawmakers that Moody’s compliance group was understaffed and lacked independence. He also alleged Moody’s knowingly issued misleading ratings on complex securities and that analysts were "bullied" by managers, who overrode their decisions to protect revenue.  Kolchinsky said he would soon meet with the SEC to discuss his charges. SEC officials said the regulator had contacted Kolchinsky about his concerns in March 2009.

McCleskey, meanwhile, sent the SEC a letter in March 2009 warning about Moody’s weak compliance department and ratings process. He said Moody’s management had ignored his warnings that the company failed to properly monitor municipal bond ratings.

The company also spurned his suggestion to erect a firewall between the compliance department and its revenue-generating units, he said.

No doubt, there are those who are still recommending munis because of their tax-free status, as a recent WSJ article demonstrated. But, the fundamentals are weak and getting worse – both in terms of the income statement and the balance sheet. These governments are soon to lose their guarantees from Ambac (and eventually MBIA despite hiving off the muni business). To my surprise, these governments are getting no federal government backstop as the California situation has demonstrated. And the Fed and Treasury are on record as saying they will not guarantee any municipal bonds. Finally, I question whether one should rely on the ratings these bonds have to make an informed investment decision. Even the junk-bond king Michael Milken, a credit analyst of note, is now warning that credit ratings are inflated.

Municipal bonds are a clear case of buyer beware.

  1. purple says

    Chanos also says ‘dump China’.

  2. Terrry says

    I am a little concerned with the rather blanket comments you and Chanos make about munis, both state & local. Let me try some quick counterpoints:

    1. Not all states & municipalities are equally risky. I don’t (& won’t) hold any California munis, but Virginia (my state of residence) has some very strong constitutional controls on spending that help keep its bonds more secure.

    2. The long-term liabilities of states and localities have been well known for years. Some states & cities are doing something about it; others are not (see above). Moreover, these liabilities may appear worse at the moment because of the recessionary downturn in revenues, but they’re not.

    3. Muni bond insurance hasn’t meant anything for at least a couple of years, and doesn’t mean anything now. It may have enabled some locales to borrow more cheaply, but it doesn’t change their credit risk.

    4. Ratings have been rightfully disgraced, at least in the absolute sense (i.e.–the certainty of repayment of a AAA bond to the “junk” status of B-rated or less bonds). NTL, I do believe the ratings, within some constraints, normally provide a sense of the RELATIVE risk among the muni bond buying opportunities. The key problem is that the ratings companies don’t really change their calls (up or down) until well after the change in the risk quality of a muni bond is publicly known. (On the latter, the same applies to stock analysts’ recommendations in mos cases.)

    In short, I think one needs to think about the relative risk of municipal bonds at a little more discriminating basis than either you or Mr. Chanos has suggested. Not withstanding the likely adverse value effects that future inflation may bring, some muni bonds are more equal–and less risky–than others and those provide a reliable stream of income and re-payment of principal.

    1. Edward Harrison says

      Terry, your comments are well-placed in that I can understand it might appear that I am saying all munis are bad. That is not what I am saying at all.

      I am saying that financial stresses will lead to some municipal bonds underperforming – perhaps causing the entire sector to underperform. I would expect there to be a dichotomy in performance based on this – with bonds from better positioned municipalities or attached to specific revenue streams to outperform. General obligation bonds are obviously of more dubious security than bonds funded by specific income streams.

      As I am not an investment advisor backed by a large legal team, I am not going to point to specific bond issues. However, I am making a general call for investors not to rely on ratings alone in determining where to invest in this sector. Do your homework and you will be ok.

  3. hue says

    I’ve seen similar “empty” cities in China for the last 15 years. And over a few years, these cities have (so far) inevitably filled up.

    The Tsinghua professor quoted in the original news report is exactly right in that regard. All of the previous rounds of physical infrastructure in China has paid off economically and socially.

    There are two numbers which define China, and is far more important than GDP in any given year:

    1) population: 1.3 billion and counting.
    2) urbanization rate: 45% and climbing.

    China’s urbanization rate will rise to 70% by 2035. If you do the math, that means 325 million Chinese currently living in rural villages will move to urban cities within the next 25 years.

    And if you do the math again, that means:

    – for every square foot of real estate currently in existence in China… it’ll be doubled over the next 25 years.

    – it also means building 15 New York’s from scratch over the next 25 years.

  4. Anonymous says

    Wanker. Sounds like his worst case is actually his best case. If the US guaranteed all of CAs GO debt wouldn’t that paper trade at 100% of USTs? Great analysis.

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