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S&P Reacts to Meredith Whitney

When famed banking analyst Meredith Whitney speaks,the market listens.

On Squawk Box Wednesday, Whitney stood by her dire predictions about municipal bond defaults. I decided to get the perspective from Robin Prunty, Senior Director in the Public Finance Ratings Group at Standard and Poor’s Ratings Service.

LL: Whitney said the muni market has the darkest pools her firm has ever seen in terms of her team getting the latest and up to date research on the muni market. Have you encountered that in your numerous reports?

RP: I don’t know what was meant by a dark pool, so I can’t speak to that. We find that we get all the information needed to provide a rating from a range of sources, per our criteria. For example, we just published a report that outlined the debt profiles of all 50 states.

We calculated each state’s tax supported debt as a percentage of expenditures, on a per capita basis, as a percentage of personal income and as a percentage of gross state product. Tax supported debt includes all general obligation, contractual and special tax or revenue bonds issued by state.

While those statistics are going up on a year-over-year basis, debt service remains a manageable component of state budgets.

LL: How large of a default are you anticipating?

RP: In this environment, we anticipate that credit quality in the municipal sector could deteriorate somewhat, leading to more rating downgrades. Yet we expect that most state and local governments will likely retain medium-to-high investment grade ratings.

We don't envision a municipal market crippled by widespread defaults or bankruptcies. We believe, moreover, that fundamental credit performance throughout the market—as measured by default rates relative to debt in the market—will remain mostly stable.

LL: Whitney says the fiscal situation facing states is getting worse. What do you see?

RP: We expect that many state and local governments will continue to operate in a constrained revenue environment, with many having to make difficult budget and policy choices. We expected that budget deliberations for fiscal 2012 would be very challenging given the slow pace of economic recovery and the phase out of federal stimulus funds.

It is important to note that there has been a steady trend of revenue growth in recent months for nearly all states but recovery remains uneven and not at the pace to offset stimulus funds and other spending pressures. Large projected state budget deficits for fiscal 2012 may be solved partly by reducing state aid to local governments. This has been the case where budgets have been finalized.

State fiscal pressures may, therefore, challenge the cash and budget management activities of many local governments. We believe liquidity management will be especially important for governments with structural budget misalignments.

LL: Whitney said she will count a municipal restructuring as a default because the state or country (she gave Greece as an example) can not repay the total amount at the original terms. Do you agree a restructuring is a default?

RP: True restructurings are a relatively rare occurrence in the U.S. municipal sector. However, we do see refinance or refunding activity in the sector. There is a difference between a refinancing and a restructuring.

In a restructuring, investors do not get repaid in full according to the original terms. Existing bondholders are forced to accept reduced principle and/or interest payments or the repayment schedule is extended. If an investor does not receive their principle and interest payments under the terms of the offering, that is a default according to our criteria.

In a refinancing or a refunding transaction which is common in the U.S. municipal sector, the bondholders get paid on time and in full according to the original terms and we do not view that as a default.

This is an important distinction and one that should not be glossed over.

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