On State and Local Governments

As Marc has said, the state and local government problem is one crisis that has not materialized yet. Looking back, the day after I heard Meredith Whitney making her debut on “60 Minutes” along with Chris Christie, talking about the problems that state and municipal governments were having, I wrote the following:

Here is a good segment on CNBC that takes another look at the muni issue which Chris Christie and Meredith Whitney raised on 60 Minutes on Sunday. Benjamin Thompson of Samson Capital says he can’t get the numbers Meredith Whitney used on 60 minutes – 50 to 100 issuer defaults on hundreds of billions of dollars in principal – to work unless we see defaults in several major municipalities.

I haven’t read Whitney’s 600 page muni report but my understanding is that Whitney’s muni research has been more geared to states and that this might be the reason for the large numbers she cites. Also, I have yet to see Whitney say that she expects these defaults to all happen in 2011. Every clip I have seen gives an indeterminate period over which this fallout is expected to occur.

My takeaway from the state and local government financial situation is that there will be defaults. The question is when and in what measure. If we see recovery through to the end 2011 and beyond, there isn’t likely to be a crisis in municipal bonds. And that means long/short relative value plays will open up for dedicated muni investors. But, for the retail investor, the complicated issues in municipal finance represent the potential for serious losses when a spate of defaults does begin in the next downturn.

Below is Meredith Whitney’s riposte to Benjamin Thompson in an interview with Maria Bartiromo, where she defends her muni crisis prediction.

–Muni Bond Crisis: What Kind of Numbers Are We Talking?, 21 Dec 2010

That is still what I think.

1. “If we see recovery through to the end 2011 and beyond, there isn’t likely to be a crisis in municipal bonds.” This has turned out to be true.
2. “And that means long/short relative value plays will open up for dedicated muni investors.” This also has turned out to be true.
3. “There will be [lots of] defaults. The question is when and in what measure.” When the next downturn hits, I expect these defaults to occur. Nouriel Roubini has said that we could see “close to $100 billion of defaults over five years.” We will just have to wait and see.
4. “But, for the retail investor, the complicated issues in municipal finance represent the potential for serious losses when a spate of defaults does begin in the next downturn.” Again, this is a forward-looking statement. We will see whether the next downturn crystallises loses for munis or not.

The bottom line is this: Forget about Meredith Whitney. State and municipal governments are carrying a load in operating and pension costs that cannot be sustained through downturns in a secular bear market as the US population ages. These downturns will not be ordinary recessions. They will increase automatic stabiliser spending, decrease tax revenue and crystallise shortfalls in pension programs in a way that is existential for these governments. And that means a spate of defaults will occur.