Kyle Bass: At municipal level, it’s “open season for defaults”
Kyle Bass doesn’t believe that the bloodletting in the muni market we have seen so far is enough to warrant taking on the increased credit risk that municipal bonds now have. Bass, who is a principal at the hedge fund Hayman Capital Management, said yesterday on CNBC that he sides with Meredith Whitney on the muni issue. And he is specific about the risks in specific classes of munis. He says states are better than cities and counties and general obligation bonds are better than project-specific bonds and municipal pass-throughs.
These are exactly the issues investors should be thinking about. There is a looming state and municipal budget crisis. The question goes to how it gets resolved. Do tax or state college tuition increases at the state level, and sales and property tax or parking fines at the city or county level do the heavy lifting? Or do we see huge budget cuts and layoffs that still are not enough to close the deficit gaps even after all of these revenue raising initiatives?
Generally speaking, I am optimistic (at least while the economy is in a cyclical upswing). Here’s how I put it in September:
My view is that states, like banks, are very much dependent on an improved economy because of their leverage to the housing market. There are numerous chinks in the armour which could spell disaster for the most indebted states. I mentioned the leverage to the housing market, but there are the underfunded pension problems, unemployment insurance borrowing, and the inability to just print money to meet debts and other problems as well. For investors, the message is buyer beware because, while CDS are soaring for the weaker debtors, clearly municipal bond prices do not reflect the financial stress. And while I broached the idea of the Fed stepping in to the situation with municipal bond purchases as the ECB had done (and continues to do) with euro zone states, this is unlikely.
Eventually the crisis is coming; the issues are structural, not cyclical. The questions are about when and in what measure, and about which specific investments are vulnerable to impairment. Retail investors do not have the financial and investing skills to make that determination and are invested because munis are safe assets. Caveat emptor definitely applies. For sophisticated investors, the question is whether the selloff so far has ben overdone so that multiple classes of municipal bonds now reflect the credit risk. Kyle Bass is saying no in all cases.
On State GO’s (general obligation bonds backed by the full taxing authority of the state), he doesn’t see defaults unless, states are allowed to file for bankruptcy, an issue now being discussed. State bankruptcy is a contentious issue because it has constitutional ramifications and would set up a pitched battle with public sector unions. I should point out it is unclear what kind of default Bass is talking about. It sounds like Bass is referring to an actual bond default in which an issuer would miss a payment rather than a technical default in which an issuer breaches the bond covenants. On counties and municipalities, Bass sees more vulnerability. Actual default is a possibility. However, it is unclear what time frame he is using.