The fact that there may be more uncertainty in the market than ever before may seem obvious. But few people understand its implications.
Wells Fargo, for instance, seems perfectly happy to rely on historical data that show very few defaults in the past. Here’s what the San Francisco based bank told clients in a note titled “Keeping Municipal Default Risk In Perspective:”
We do not expect a significant increase in municipal defaults for many of the reasons mentioned in this paper. As municipalities weather this period of fiscal stress, an increase in headline risk and ratings downgrades is quite likely, which potentially increases the risk to investors holding individual bonds.
However, the elevation in headline risk does not mean that diversified municipal bond investors are taking on inordinate amounts of risk. As shown, actual defaults in municipal bonds are exceedingly low compared with corporate bonds, and their recovery values are typically much higher, particularly in general obligations issued by cities, counties, and states.
This is reliance on past performance to predict future results.
Everyone who has ever read a prospectus knows that you aren’t supposed to do this. But it is particularly egregious following the series of under-predicted catastrophes we’ve witnessed recently in the credit markets. And it is identical, in form and content, to what many in the mortgage market were telling John Paulson as he sought to build his fund to short the U.S. housing market. Paulson got rich, many of them went out of business.
Pimco is far more sophisticated in its approach. It acknowledges that relying on past performance of the muni market is a mistake:
One common refrain from some in the muni optimist camp is that historical municipal default rates have been extremely low, which should provide confidence that municipal credits can find ways to weather fiscal storms when they arise. We, however, would be very cautious around the relevance of historical municipal default statistics. If the last few years have reminded us of anything, it is that historical default patterns can be shattered given different initial conditions, as seen so painfully in investment grade corporate default rates during the crisis, not to mention defaults on structured credits rated AAA by the agencies.
This would be very good if that’s where it ended. But Pimco goes on to claim that expertise can be employed to overcome the limitations of historical statistics.
“It is better, we believe, to look in detail at state and local municipalities’ current ability to service their liabilities than to simply rely on their historical default track record,” Pimco writes.
The problem with this approach is that precisely because the record of muni defaults is so limited it is impossible to evaluate from the data whether state and municipalities will be able and willing to service their liabilities. We do not have enough of a record to create a reliable model through which we could feed data about the financial health of states and cities and predict default rates.
To put it slightly differently, we’ve had so few defaults in the munispace that we cannot confidently say what characteristics make a state more or less likely to default. We do not know which characteristics are relevant and which are not. We do not even know that the “relevant characteristics” exist—defaults might be completely unpredictable.
Does divided state or city government make default less likely or more? What about a recent change in party control? The presence of a balanced budget requirement in the state constitution? What is the effect of strong municipal unions? How about strong tax-payer opposition to tax hikes?
Those questions are unanswered right now—because this is our first modern experience with risky muni debt. They may be unanswerable. And because we don’t have those answers—and neither do the so-called experts—investors should be extremely skeptical about claims of expertise.
What the experts have is untested theories about what will or what won’t be predictive of a default. In short, they have uneducated guesses because the education needed is unavailable.
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