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Muni bond market throwdown: How bad could defaults get?

December 23, 2010 |  7:08 am

Star banking analyst Meredith Whitney has been saying for months that the next phase of the housing meltdown would be a local-government financial crisis. Last weekend she put a number on it, asserting that "hundreds of billions of dollars" of municipal bond debt would end up in default.

Whitney, appearing on CBS' "60 Minutes," was interviewed on correspondent Steve Kroft's segment on the "day of reckoning" for municipal finances.

Whitney Given the pounding that the tax-free muni market has taken since late October, driving bond prices down and yields up, Whitney's comments were a bond salesman's worst nightmare. The segment aired just after the muni market seemed to be stabilizing late last week.

So far this week the market has remained relatively calm, although a report Wednesday from the mutual fund industry's trade group showed that muni fund redemptions jumped in the seven days ended Dec. 15 as more investors opted to cash out.

Whitney is right that many states and municipalities face deep-rooted budget woes, of course. But could that really lead to "hundreds of billions of dollars" in muni defaults in a market worth $2.8 trillion in all?

Joe Mysak, Bloomberg News' resident muni columnist, was mystified by Whitney's prediction. He wrote on Wednesday:

Hundreds of billions of dollars? The one-year record, set in 2008, is $8.2 billion. You can see how an estimate of “hundreds of billions” would get people’s attention.

There are a lot of reasons to be doubtful about the health of the municipal market right now. . . . Tax revenue is down, public pension and health-care liabilities are up, the federal government’s bailout money to the states is running out and the chances that those funds will be replenished are remote.

And yet -- hundreds of billions of dollars in default? The number is in the realm of the fabulous. If pressed, I would say that we might see between 100 and 200 municipal defaults next year, maybe totaling in the $5 billion or $10 billion range.

Mysak noted that Whitney doesn't believe that any of the 50 states will default (there is no allowance under U.S. law for states to file for bankruptcy). That means her expected default total would have to comprise large numbers of cities, counties and other municipalities. In fact, she said she expected  "50 to 100 sizeable defaults," without naming names.

What Whitney describes sounds like a contagion -- a surge in the number of municipalities deciding on the nuclear option of giving up on their current financial plight and trying to start over.

But municipal bankruptcy under Chapter 9 of the federal bankruptcy code is no simple affair, as Michael Corkery writes in the Wall Street Journal. He noted that 21 states don't even allow their municipalities to use Chapter 9.

And as Mysak noted, just walking away from bond debt wouldn't save many municipalities much money in the scheme of things; their greatest liabilities are pension and health-care benefits for employees, not debt service.

Still, holders of government bonds everywhere may increasingly feel as if they've got targets on their backs. That is certainly true in Europe: The European Union last month decided that any further EU bailouts of member countries after 2013 could require bondholders to take haircuts.

But "hundreds of billions of dollars" in U.S. muni defaults, and soon?

Dick Larkin, a veteran muni analyst at Herbert J. Sims & Co., went on Fox Business Network on Wednesday to call Whitney's prediction "ludicrous" and "irresponsible."

“There will be more defaults. But nothing coming close to hundreds of billions of dollars," Larkin said. "I am putting my career on the line by saying that ain't going to happen. If she’s right she will be a hero and I will be out of business. . . . I’ll put my career on it.”

-- Tom Petruno

 Photo: Meredith Whitney. Credit: Louis Lanzano / Bloomberg News

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