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The Bulls and Bears Agree: Muni Default Risk Is Greater Than Ever

Photo by: John Carney

The words debt and crisis have become terribly associated with each other over the last few years. We have had a mortgage debt crisis, a sovereign debt crisis and now a lively debate over the likelihood of a municipal debt crisis.

Everyone agrees that the muni debt is undergoing a serious and perhaps permanent change. Muni debt was once viewed as almost risk free. Now even those who advocate investing in muni debt acknowledge the “very real credit risks in the municipal space,” as Pimco put it in their most recent note on munis.

The debate underway now is about the likely severity and scale of muni defaults. Or, more precisely, we have a debate about how to fairly price the default risks inherent in muni credits. On the one hand, there are analysts like Meredith Whitney and hedge fund managers like Jim Chanos who warn that investors are taking on too much risk for too little yield. Whitney has predicted a “wave of defaults” that could be in the “hundreds of billions of dollars.”

On the other hand, there are the bond fund managers, economists and others like CNBC economics reporter Steve Liesman, most of who are more bullish on muni credits.

Pimco, for example, thinks the market has “swung too far into default panic.” Wells Fargo echoes Mark Twain, saying “Reports of defaults have been highly exaggerated.” In a piece titled "Why The Muni Bond Crisis May Be Exagerated,"Steve Liesman calls the current state of the market a "panic."

So what's going on? Well, despite what you might think from some media reports, the distance between the bulls and the bears is not that great.

A quick test: who do you think said this?

“Now, however, with many states and local governments struggling to close large deficits, it’s time to acknowledge that defaults could happen, even in large and systemically important municipal issuers.”

Was it Meredith Whitney? A fund that is shorting muni debt? A doomsaying market pundit? Nope. That’s from Pimco.

So how can Pimco and other bond specialists still be launching new muni funds in that kind of risky environment? How can they conclude that the market is mispricing risk by overestimating the size and severity of defaults?

The answer seems to be based on a claim of expert knowledge and forecasting ability. Pimco and others believe that they can accurately predict defaults, protect against losses through selective and diversified strategies, and outsmart the market. It makes sense to invest in munis, in other words, because the market is inefficient, panicked, and over-pricing risk.

I take these kind of claims as evidence of overconfidence. In a series of posts today, I’ll cut through a number of over-looked fragilities in the muni space, political science naiveties, and other blind spots committed by those seeking to reassure investors about investing in munis. I’ll show how concepts such fallibility, reflexivity, and political risk are ignored or misunderstood in the muni landscape. The cumulative effect of this collection of errors is enough to not only undermine the case for investing in munis despite the panic, it suggests that the alleged panic might not yet have gone far enough.

What I’m not doing is forecasting muni defaults or the future prices of muni bonds. In fact, I think my analysis reveals that muni bonds are particularly poor subjects for forecasting. There are too many unknowns and unknowables, including the risk of bailouts that would leave muni bond holders whole.

Next up: Why there’s no such thing as a muni default expert and why that’s a scary thing.

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