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The Muni Market and Meredith Whitney’s Redemption

Meredith Whitney, it turns out, wasn’t exactly wrong.

In December 2010, the reknowned analyst told 60 Minutes that the municipal bond market faced “hundreds of billions of dollars” worth of defaults. The call struck the muni world with force…between December 2010 and early February 2011 investors pulled $14 billion out of muni bond funds. And 4th quarter 2010 returns were the lowest in 16 years.

But those epic defaults haven’t materialized. Since Whitney’s call, defaults have amounted to something like $2.6 billion, in a muni market that stands at around $3.7 trillion. And because of that, Whitney has had to punt against some harsh criticism.

But while those massive defaults haven’t happened, she had a point. Her point was that municipal finances in this country are a train wreck. And she was absolutely right about that.

While defaults are not overwhelming the market, they have doubled in the past two years compared with the period of 1970 to 2009. And defaults are not overwhelming the market in part because municipalities are choosing to default on insured debt. Of course, the upside there is that bondholders get paid. But if insurance companies have to step in and make payments on bonds because municipalities can’t, it’s not a sign of improvement.

That’s not to say there haven’t been glimmers of hope. Since state revenues hit bottom in 2010, we have had eight quarters of revenue growth. And over the past year, 45 states have seen their revenue increase, according to the Rockefeller Institute of Government.

That in itself is a good thing. But the problem is that the recession created the biggest collapse in state revenues on record, and they fell so far that most states still have not fully recovered…revenues are still 7% below pre-recession levels (as of the 3rd quarter 2011, according to the Center on Budget and Policy Priorities). And “the problem is that states were down so deep that they effectively have lost three years worth of growth”, according to Rockefeller’s Robert Ward.

As revenues improve, budget shortfalls are improving: in the last fiscal year, 42 states closed gaps totaling $103 billion…but they are still large by historical standards. Thirty states project budget gaps totaling $49 billion for fiscal 2013. And even if revenues continue to grow at the current pace (not likely), it would take 7 years to get budgets back to normal.

And while states try to dig their way out of the red, they have to dig without much help. In 2009, the American Recovery and Reinvestment Act gave states emergency aid to the tune of $140 billion over a two and a half year period. But the federal government let most of that expire at the end of fiscal 2011. And not only is that help not being extended….the government is looking to trim its federal funding for states further. Having their lifeline cut isn’t going to make municipal financial conditions any better.

If Meredith Whitney was wrong about anything, she was wrong to get too specific in her prediction. But she was right to draw attention to the glaring and ugly reality of municipal finances.

And maybe a little of that reality is hitting home. iShares S&P National Municipal Bond Fund (MUB), a proxy for the muni bond space, has tumbled over the last month, and is breathing on an intermediate sell signal.


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