Trading the Muni-Meltdown

December 23, 2010
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Meredith Whitney made headlines over the weekend appearing on “60 Minutes” and predicting a devastating year ahead for municipal bonds.

“You could see 50 sizeable defaults…

Fifty to 100 sizeable defaults…

More…

This will amount to hundreds of billions of dollars’ worth of defaults.”

~Meredith Whitney

While the Wall Street establishment has been quick to react and attempt to discredit these “bold assumptions,” it isn’t too difficult to see how this bearish scenario could play out.

State, and local governments across the US are facing budget shortfalls – some of which are nearly impossible to overcome. The state of California has resorted to issuing IOUs in the past, and it looks likely that this will happen again in 2011.  High unemployment leads to lower income tax, and property taxes are also being revised lower with the declining value of real-estate.

Since municipalities don’t have the “luxury” of printing their way out of deficits, the risk of default becomes pretty sobering.  More importantly, the trickle down effect – or more accurately the waterfall effect could significantly impact the broad US economy.  Not only are bondholders on the hook, but suppliers, contractors, employees and of course taxpayers will all feel the sting when these defaults run their course.

Fed Bailout and the Moral Hazard Issue

One of the arguments against a major municipal default scenario is the assumption that the federal government will step in and bail out many of these municipalities.  This would make sense because fed has a vested interest in propping up the weak recovery.

If the fed is willing to step in and support financial institutions deemed “too big to fail,” then why wouldn’t they also support individual city and state governments – many of which are MORE important to voters.

So municipal bond holders may not have quite as much risk as Whitney implies because of the potential federal backstop in place.  But a federal bailout raises issues as well.  Should all US taxpayers be responsible for fiscal irresponsibility in California, or for the massive debts owed by Illinois?  More importantly, what message does a federal bailout send to other municipalities, to bondholders, and to vendors and contractors serving these municipalities?

The issue of moral hazard can lead to poor decision making for years to come – if not generations to come.  Just as an auto driver with a premium insurance policy might have less reservation about making a risky turn or parking in a sketchy neighborhood, municipalities who know they are fully backed by the US government are much more likely to make poor budget decisions for years to come – with the confidence that any negative repercussions will be largely shouldered by Uncle Sam.

This is a classic situation where one party collects ALL potential benefits but SHARES in the potential risk.


Voter Backlash and Easy Targets

If the November election taught us anything, it is that voters are now paying attention, and they will make politicians PAY for their mistakes.  Many are still seething over the way the US government essentially funneled bailout funds directly to investment banks during the 2008 / 2009 financial crisis.

A federal bailout of municipal governments or muni-bondholders (whether necessary or not) could set off another round of backlash, and further erode confidence in Washington’s ability to navigate an economic recovery.  Congress knows this, and while they may still feel responsibility to offer a helping hand, they will certainly be looking for ways to minimize the fed’s involvement wherever possible.

And that brings us to some of the easy targets in this whole scenario.  The bond insurers who have underwritten many of the failing debt in question.

The financial insurance business is much like the life insurance or auto insurance market.  The underwriters charge a fee and usually get to keep the premium leading to a stable profit.  But when something goes wrong with the insured bond, the insurance company is then on the hook to “make investors whole.”

Financial insurance companies will be an easy target for the federal government because these companies have largely already pledged to bail out the municipalities should a default occur.  Forcing the insurers to meet their obligations before the fed steps in with any support makes sense both politically and practically.

These insurers are contractually obligated to cover many of the debts issued by municipalities.  Of course if all of these contracts are called in at once (which would happen in the Meridith Whitney case of massive muni defaults), the financial insurance companies may very well default themselves.  Looking at the balance sheets of the insurers in question, there simply isn’t enough capital to cover a widespread rash of defaults.

From a political perspective, officials could save face by forcing the private sector to foot the majority of the bill for the rescue package – and then the Fed could step in afterwards and offer different rescue packages or tax incentives to help jump-start growth once the municipality is restructured.

Trading Opportunities

From a trading perspective, there could be some excellent opportunities to short the bond insurers – companies that would be devastated if widespread municipal defaults occurred.

MBIA Inc. (MBI) took a tremendous hit in 2007 as the financial crisis began.  The company had been very active in underwriting Mortgage Backed Securities (MBS) – collecting premiums for insuring the packaged, sliced and diced – fraud-laced – mortgage bonds.  At the time, the management team looked like a bunch of geniuses as they collected fees for insuring these “fail-safe” bonds.

But as we know, the asset-backed securities became worth much less (or more accurately worthless) when the prices of homes began to decline and over-leveraged homeowners couldn’t keep up with the payments.

Today, MBIA is once again vulnerable to a rash of muni-defaults, and is unlikely to have the capital to meet these liabilities.

Typically when setting up a short position, I’m considering how investors will react to a business that is seeing growth decline or possibly a contraction in earnings.  But in the case of MBI, there is a significant possibility of a complete bankruptcy – with the stock price dropping all the way to zero.

Financial insurers have been rallying lately because of the possibility of collecting damages from mortgage loan originators.  This would be a positive event for the industry, but could be completely offset by a collapse in the muni market.

At this point, traders are largely turning a blind eye to the liability side of the story, but that could change in a heartbeat once one or two major municipalities begins to falter and the fed reacts with less support than expected.

A break below $9.50 offers an interesting inflection point for active traders, and we’re watching the area closely with an eye towards taking significant short exposure.

Assured Guaranty (AGO) commands a bit more respect as the company largely avoided the mortgage crisis by not underwriting many of these risky loans in the first place.  The management team was willing to put up with a bit of ridicule for not chasing the profits during the heyday of MBS underwriting – and then had the last laugh when competitors took a huge financial hit.

But AGO is particularly vulnerable at this juncture because of its concentration in underwriting muni securities.

True, the muni bond market has been much more stable than the MBS market – avoiding significant losses up to this point.  But if Whitney’s expectation comes even remotely close to being accurate, AGO’s concentration insuring municipal bonds could put the company’s future in jeopardy.

Similar to MBI, Assured Guaranty had a decent summer when it appeared mortgage originators would be on the hook for fraud.  AGO purchased acquired a mortgage underwriter at a very attractive price during the darkest days of the crisis – and may now be able to collect on these fraudulent mortgage issues.

But the expectation of this cash infusion is largely priced into the shares at this point – with the municipal risk being a more likely catalyst for 2011.

On Wednesday, the stock broke below the 200 EMA, the 50 EMA and the 20 EMA in relatively high volume.  Of course a day does not a trend make, but the bearish action suggests investors may be in the early stages of liquidating positions – a process that could take some time and offer a good risk / reward trade for us heading into the new year.

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