Meredith Whitney: Next Shoe to Drop Is Municipal Bonds

Meredith Whitney has a new report out that she has been working on for two years called "Tragedy of the Commons" in which she rates several U.S. states. Based on Whitney’s analysis, problems in municipal finance could be the next systemic risk down the pike (video of Whitney speaking to CNBC’s Maria Bartiromo below runs 10 minutes)

The states are highly leveraged to the housing market via tax revenue, meaning that they have been crushed by the housing downturn. Whitney is on record as saying housing will double dip, which obviously implies additional tax revenue shortfalls. Whitney says that the banks are much better positioned for a housing double dip than the states. Today’s data from Case-Shiller does imply a weakening in the housing prices which will become apparent in the next month’s data.

According to Fortune, the rankings include 15 states rated on four dimensions: their economy, fiscal health, housing, and taxes. Whitney’s rankings are as follows:

Worst states

1. California

2. New Jersey, Illinois, Ohio (tie)

3. Michigan

4. Georgia

5. New York

6. Florida

Best states

1. Texas

2. Virginia

3. Washington

4. North Carolina

Neutral states: Pennsylvania, Maryland, Massachusetts

At Credit Writedowns, we have been talking a lot about states and municipalities as a weak link in the economy. See some of Fred Sheehan’s posts on this topic. We highlighted an analysis by Rick Bookstaber in which Rick also says he thinks that municipals and states are the weakest link. The key passages in his analysis read:

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

1. Problems occur when things get leveraged and complex (and thus opaque).
2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages).

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.

Source: States Are Poised to Be Next Credit Crisis for US: Whitney – CNBC