The metamorphosis of the muni market | FT Alphaville

The metamorphosis of the muni market

Wednesday’s House hearing into state and municipal debt had a touch of the “Scottish play” about proceedings.

When Meredith Whitney was finally mentioned, Chairman Patrick McHenry quipped that the rules had been broken.

The hearing itself had its fair share of foreboding tragedy with four “experts” lining up to discuss states’ woes. We’ve previously touched on these views, but if you want more here are deliberately short summaries and links to their testimonies:

1. David Skeel, University of Pennsylvania: a bankruptcy law for states is feasible and desirable. (Testimony.)

2. Iris Lav, CBPP: don’t confuse short-term budget problems with longer-term issues; both are fixable. (Testimony.)

3. Eileen Norcross, Mercatus Center: states are in big trouble and need to reduce spending (especially on medicaid) and pensions obligations. Pity Illinois. (Testimony.)

4. Nicole Gelinas, Manhattan Institute: a bankruptcy law is more trouble than it is worth — states need to cut spending and renegotiate deals with unions. (Testimony.)

Gelinas actually concluded with an apocalyptic smackdown of Congressional doom-mongers:

Finally, if Congress wants to raise the prospect that a state could someday default on its debt, it would have to raise the prospect that a large bank or money-market fund, too, could suffer large losses as a result of that default. After all, banks own $229 billion in state and local debt, and money-market funds own another $332 billion. Creating a process for a state or multiple states to default on debt obligations without first ensuring that a large bank can go through the bankruptcy process could create economic chaos, forcing Congress, in the end, to save the state or the bank. This is hardly a good choice.

Hard to disagree with that point.

Overall, though, the hearings added little to our understanding of the municipal market (as opposed to the fiscal situation).

Outside of the nation’s capital, the muni market continues its change from a low-risk asset class to a credit-asset class, and all the fun and games that come with it. As Felix Salmon notes, this migration to a “bumpy” marketplace is more important (and more interesting) than the cacophony associated with Whitney.

As PIMCO — far from an impartial observer, obviously — explains in a note out on Monday:

The bad news, then, is that municipal markets must permanently change to understand and more fairly price the default risk inherent in muni credits.

Incidentally, Whitney supporters have been saying that this was all she was trying to point out; an earnest but vastly too-charitable defence.

PIMCO does, however, downplay the potential reverberations from the changing muni market. While accepting that “a meaningful increase in the incidence of default” can’t be ruled out (and that historical default rates are nearly irrelevant), PIMCO gives two main reasons for why everyone should chill out on munis.

Firstly, it argues that the structure of municipal debt is conservative: the vast majority of munis do not have too much debt, interest rates are low, budget accounting rules can overestimate deficits, debt is nearly always fully amoritising and pension troubles are for 2015 not 2011.

Secondly, PIMCO argue that if/when defaults do occur, they will be isolated incidents. From the note:

[re VRDO issuers] Importantly, it appears as though these defaults would come from systemically unimportant issuers, particularly special purpose issues financing multi-family housing or health care properties, many of which came to market in the go-go issuance years of 2005-07, but which are not core holdings of most muni managers. Their defaults are unlikely to have a significant contagion effect onto the broader muni market, in our view, let alone onto the broader credit markets.

[re “sand” states] Even in these states, however, the municipal market can survive an uptick in defaults among systemically unimportant issuers.

All decent points, but we worry that by focusing only on the systemic impact of default, the consequences of falling prices/rising yields and changing investor classes are underappreciated. Contagion can happen without defaults.

Investors have little recent experience with a volatile muni market — complete with shorting by hedge funds and new ETFs — and we don’t yet have a good sense of how this will influence borrowing and spending decisions in states and localities. NB – Issuance has been relatively low so far in 2011.

All of which may give the House more to talk about at future hearings.

Related links:
Hedge funds search for way to short munis – FT
The bumpy road ahead for munis – Felix Salmon
Meredith Whitney and the muni fifth dimension – FT Alphaville