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2 Bloomberg Brief Muni Meltdown 2

3 Bloomberg Brief Muni Meltdown 3 MUNI MANIA: A TIMELINE FEBRUARY 2009 If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. Warren Buffett APRIL 2009 Moody s assigns the U.S. Local Government Sector a negative outlook SEPTEMBER 29, 2009 Dark Vision: The Coming Collapse of the Municipal Bond Market Frederick J. Sheehan, published by Weeden & Co. DECEMBER 2009 Are State Public Pensions Sustainable? Joshua D. Rauh MARCH 30, 2010 State Debt Woes Grow Too Big to Camouflage The New York Times APRIL 4, 2010 Once a few municipalities default, there is a risk of a widespread cascade in defaults. Richard Bookstaber, blog APRIL 15, 2010 This isn t capitalism. It s nomadic thievery. Looting Main Street, by Matt Taibbi, Rolling Stone SUMMER 2010 How to Dismantle a Muni-Bond Bomb Steven Malanga, City Journal OCTOBER 5, 2010 Cities in Debt Turn to States, Adding Strain The New York Times NOVEMBER 29, 2010 Give States a Way to Go Bankrupt David Skeel, The Weekly Standard DECEMBER 19, 2010 Hundreds of billions Meredith Whitney, on 60 Minutes JANUARY 20, 2011: Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm Center on Budget and Policy Priorities 21-page white paper AUGUST 2011: SPRING 2010 Beware the Muni Bond Bubble: Investors are kidding themselves if they think that states and cities can t fail. Nicole Gelinas, City Journal SEPTEMBER 2010 The Tragedy of the Commons Meredith Whitney NOVEMBER 16, 2010 California will default on its debt. Chris Whalen to Business Insider DECEMBER 5, 2010 Mounting Debts by States Stoke Fears of Crisis The New York Times DECEMBER 24, 2010: I can t make the numbers work. If you look at the 10 largest cities and the 25 largest counties in the country, that s $114 billion in debt outstanding. So you gotta basically have New York, Chicago, Phoenix, Los Angeles these cities start to default. Ben Thompson, Samson Capital, on CNBC [I don t care about the] stinkin municipal bond market. Meredith Whitney to Michael Lewis

4 Bloomberg Brief Muni Meltdown 4 INTRO An old-media kind of guy, I still keep file folders of stories, blog entries, clippings, messages and reports printed out and more or less sorted. Back in early 2009, I started a file labeled Hysteria to hold the physical evidence of what I thought the most unusual and even outlandish claims being leveled against an asset class I have spent 33 years writing about municipal bonds. Over the next couple of years, the file swelled. I started another. And another. I didn t even include Meredith Whitney. She got an entire file of her own. I collected so much material that I decided to use it as a presentation to the Bond Attorneys Winter Workshop one year. Even then I only got to use the high-points, or low points, if you prefer, entering each exhibit into evidence. I considered this clever. Show me a revenue stream and I ll show you a bond issue, is an old banker s axiom. The writer s equivalent is probably, Show me a box of research and I ll show you a book. Or, in this case, a special supplement. And so here we are. In 2010, municipal bonds, hitherto known only as secure, boring investments, if sometimes a little weird, were front-page news. It was stated with some confidence that the entire market was going to go bust. Of the Great Municipal Market Meltdown so confidently predicted for 2010, 2011, 2012, and so on I think we are now finally able to say, That didn t happen. As it was being predicted, I observed that the reason it wasn t happening was because that doesn t happen. In other words, the various experts then weighing in about state and local governments coming mass insolvency and/or repudiation didn t know what they were talking about. That didn t stop what I termed their Inexpert Testimony from being offered. And widely (and unfairly, I thought) quoted. I define meltdown here as its proponents did: widespread default or outright repudiation of municipal bonds. There were a number of (non-muni) analysts and observers eager to forecast just this possibility. Others contented themselves with stoking hysteria in regard to public pensions. One even expressed outrage over Wall Street s underwriting and banking relations with Main Street borrowers. The blowup to come, we were assured, was going to be almost operatic. The more I leafed through these bulging files in retrospect, and recollected in tranquility, as the poet says the more I asked, How did this come about? Why were so many people who were little more than tourists in MuniLand taken so seriously? Why was the opinion of those who did know what they were talking about so heavily discounted? What lessons can investors learn from this? Because lots of investors, especially after Meredith Whitney made her famous call on 60 Minutes in December of 2010, sold both muni mutual fund shares and individual bonds, sometimes at fire-sale prices. They wanted to get out at any price. Panic was in the air. There s no one answer. There are lots of answers. Inside In the Beginning Particular and Specific...5 The Undiscovered Country Just Look!...8 The End of Something Splendid Isolation No More...9 Dark Vision Bombs Away...10 The Coming Collapse In Sum...11 Into the Abyss Dump Munis...12 Public Pensions We Have a Problem...13 Media Frenzy Everyone s Meltdown...16 The Market Responds to Its Critics First Responders...19 Oh, Meredith Hundreds of Billions...23 After Hundreds of Billions Victory Lap...24 Returning Fire That s Enough!...26 What Happened, Lessons Learned Age of Twitter...27 Appendixes To the Foregoing Work...30 There s no one answer. There are lots of answers.

5 Bloomberg Brief Muni Meltdown 5 I: In the Beginning Our story begins in There may have been hysterical commentary about the condition of the municipal bond market before this. There probably was; I just don t recall it. Maybe it lacked a certain intellectual heft, and so had little impact on me as I read it. More likely, it was submerged in the round-the-clock hysteria then surrounding nothing less than the state of capitalism in the free world. The recession that had begun in late 2007 and accelerated in 2008 still had a way to go. Faced with Wall Street firms going bust, mass firings, the housing price collapse and 401(k) plans evaporating as the stock market plummeted, it was hard for municipal bonds to make the front page. They tried. Two events in particular had rocked munis in In February, the $330 billion auction-rate securities market froze after Wall Street banks stopped providing backstop bids for the stuff. The market had long relied on a convention the Street could no longer afford instant liquidity. The result: Investors in many auction issues could see their money, but couldn t lay their hands on it. It would take years to remedy the situation. Rise of the Insurers This was damaging enough to the market s psyche. Even worse was the downgrade of most of the AAA-rated municipal bond insurers. Bond insurance was perhaps the most successful franchise in the municipal bond market, originating in 1971 and reaching a peak penetration of 57 percent of the new issue market by Bond insurance was also the thing that commoditized the market. No longer did investors have to study the innumerable details of a bond issue s structure and security. Now there was just this thing you could buy called a municipal bond that produced interest that was tax-exempt and that was incredibly safe and secure in the first place and was now even insured as to repayment of principal and interest and so rated AAA. Or so it was thought for a very brief period stretching from perhaps 1985 to the collapse of the insurers in The insurers had proven to be in the right place at the right time. They were even, helpfully, a little early. States and municipalities were just about to embark on a borrowing binge, spurred in part by the threat, real and imagined, of tax reform that would prohibit them from financing certain things with tax-exempt securities, and then by a decline in interest rates that sparked a wave of refinancing, and finally by a boom in what we may term bankerly creativity. I m sure the rise of suburbs beyond the suburbs and their concomitant needs for infrastructure like streets and sewers and schools was part of it, as was the later urban renaissance. Analysts could take cold comfort in the fact that the insurers didn t lose their AAA ratings because of anything they d done in the municipal market. Their sin was expanding into asset-backed securities, a move inspired as much by stockholder interest in returns as demanded (well, almost) by the ratings companies, which urged the insurers to expand into more lucrative areas of business. And here it might be appropriate to say why commoditization was so welcomed in this market. As investor Paul Isaac once put it to me over cocktails, So what you re saying is, municipal bonds are particular and specific to a remarkable degree. Isaac was responding to my amazement and frustration trying to understand a subject that seemed endless and unfathomable. This was back in the early 1980s. I stole his phrase and have used it ever since, only occasionally substituting insane for remarkable. This turned out to be the single most important observation about municipal bonds I have ever heard. It explains so much. It explains everything. The multifarious ( of great variety; diverse according to Webster s) nature of municipal bonds is one of the reasons Source: Nick Ferris/Bloomberg Joe Mysak I became so convinced that a national meltdown was unlikely. We re not talking about dozens or scores of issuers, but tens of thousands. The Census of Governments done by the U.S. Census Bureau every seven years shows that there are just over 90,000 governmental entities in the U.S. It has been estimated by the Municipal Securities Rulemaking Board, the market s self-regulatory organization, that perhaps 50,000 have borrowed money in the municipal market at some time or other. They have done so with serial and term bonds, with notes, with variable- and the aforementioned auction-rate securities, using their full-faith and credit taxing power pledge, their limited taxing power pledge, their mere promise to appropriate money for debt service, and more often than not (since the 1970s), with the promise of specific revenue streams. And did I mention the companies, like airlines, that also borrow in the municipal market? Sucker s Bet In fact, it s a rare government that uses its general obligation, full-faith and credit pledge to sell bonds to borrow money. What was once termed the shadow government, and not in an approving way, is the primary engine of borrowing in today s continued on next page...

6 Bloomberg Brief Muni Meltdown 6 continued from previous page... muni market: a network of districts, agencies, authorities and public corporations, staffed by their own professionals and insulated, if you will, from the public and even from duly-elected government officials, like a city council, for example. The decentralized nature of municipal issuance turns out to be one of the market s great strengths. Add to this the perpetual nature of most governmental entities and you can see why a mass municipal meltdown was a sucker s bet. Perhaps only someone who has looked through 12 or 20 screens of a Bloomberg terminal s Municipal Bond Ticker Look Up can appreciate this. Type in a name of a municipal issuer and you get screen after screen of apparent direct relations. Who are all these guys? The auction-rate freezeout and the collapse of the bond insurers were stunning stories, unimaginable for anyone familiar with the things, yet in the context of the times in 2008 just more collateral damage from the subprime mortgage implosion. More bad news was on the way in 2009, as the recession deepened and states and municipalities saw tax revenue dwindle. The recession officially ended in June of State tax collections declined versus the same period the previous year in every quarter from the fourth quarter of 2008 to the fourth quarter of 2009, according to the Nelson A. Rockefeller Institute of Government. That s another feature of the municipal market; state and local government isn t on the front end of recession, but on the tail. Public finance is a lagging indicator. This is why most states and municipalities were still hiring in 2008, even as the private sector was shedding hundreds of thousands of jobs. Acronym Mad Now we come to the first major market call that attracted my attention as being a little exaggerated if not hysterical. Because, let s face it, Warren Buffett is no hysteric. The reference to munis came in the February 2009 edition of the letter Buffett sends annually to Berkshire Hathaway shareholders. Berkshire had launched Berkshire Hathaway Assurance Company (or BHAC: the bond insurance business is acronym-mad) in 2008 as a municipal bond insurer. Under a section of his letter entitled, Tax-Exempt Bond Insurance, Buffett recounted BHAC s year, which at one point included an offer to reinsure the other largest monoline municipal bond insurers existing books of business. The insurers rebuffed the offer. Buffett said BHAC would remain very cautious about the business we write and regard it as far from a sure thing that this insurance will ultimately be profitable for us. The reason is simple, though I have If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. Warren Buffett never seen even a passing reference to it by any financial analyst, rating agency or monoline CEO, Buffett wrote. He continued, The rationale behind very low premium rates for insuring tax-exempts has been that the defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn t exist before 1971, and even after that most bonds remained uninsured. Buffett continued: A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds virtually all uninsured were heavily held by the city s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings. If, Buffett posited, all of the city s bonds were insured by Berkshire, would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not, he answered. At a minimum, Berkshire would have been asked to share the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial. In other words, the city would have defaulted on its insured bonds, leaving the insurer to pay the debt service. At some point, it is assumed, the city and the insurer would sit down and negotiate the terms of repayment, but not in full. Simply Staggering Buffett observed that local governments were going to face far tougher fiscal problems in the future. The pension liabilities I talked about in last year s report will be a continued on next page...

7 Bloomberg Brief Muni Meltdown 7 continued from previous page... huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at year-end The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering. So far, so good. New York City s nearmiss with bankruptcy, I know, was a closerun thing, with the state playing a powerful role in the rescue, along with the United Federation of Teachers. Buffett s theory of the role insurers might play in a meltdown was somewhat prescient, as the Detroit bankruptcy has shown us: the insurers have a seat at the table, and are indeed expected to contribute to Detroit s future, by taking less than they are owed by the city. Buffett s concerns about public pensions were nothing new or astonishing. Numerous analysts pointed out how they had suffered after the tech bubble burst only a few years before. (It is worth noting, however, that in 2000, the so-called funding ratios of public pensions topped 100 percent). And then Buffett went just a little bit further. When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop solutions less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be Municipal bonds are particular and specific to a remarkable degree. Paul Isaac, Investor highly correlated among issuers. This last sentence can be parsed any number of ways, and I m not going to attempt it here. But then, this: If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer? Buffett concluded that insuring municipal bonds has the look today of a dangerous business. The headline words were dangerous business. The real story was in the previous two sentences, about 1) a seeming contagion in municipalities actively seeking to stiff their creditors and get away with it, and 2) elected officials choosing not to make some very hard choices. I didn t know it at the time, of course, but the Buffett letter was the first salvo in what would become a muni meltdown barrage. At the time, I thought it interesting, purely because munis were so unremarked upon in general. I also thought it a trifle overwrought, said so in a column, and was surprised at how many s I received from the Great Man s minions, eager to denounce unbelievers. Much worse was to come.

8 Bloomberg Brief Muni Meltdown 8 II: The Undiscovered Country There wasn t a lot of big press coverage of municipal finance because editors found the topic almost stupefyingly dull. Source: Bloomberg/Daniel Acker Warren Buffett In 2008, Buffett made his overtures to the beleaguered bond insurers. The possibility that they might lose their top credit ratings was already a hot topic of conversation among market participants, not least because investor Bill Ackman was shorting the stock of the biggest insurer, MBIA, and he made sure the Wall Street Journal knew it. But there were a lot of other things being discussed in the municipal market, as well. How would a decline in tax revenue affect budgets and credit ratings? How would states and municipalities deal with stock market losses that had blown a hole in the value of the assets they had put away to cover pension liabilities? Could they manage the expense of Other Post- Employment Benefits, previously handled mainly as a pay-as-you-go expense? Then there was the SEC s ongoing investigation into bid-rigging and price-fixing in the municipal reinvestment business, the whole murky world that exists after issuers sell bonds and need to invest the proceeds. The use and proliferation and opacity of swaps was finally getting some attention, too. Everybody s Talking The Municipal Securities Rulemaking Board, for its part, was in the midst of a push to reform disclosure and enhance price transparency, as well as regulating municipal advisers and establishing who owed issuers fiduciary responsibility, among other things. Yes, all of these topics were being discussed in the muni market. Just because these subjects only sporadically appeared in the major newspapers and almost never made it to television and cable news doesn t mean that they weren t being talked about, and covered by local newspapers and the very specialized financial press, that write about munis. There was a lot of ferment going on in municipals in the 2000s. And yet, a common claim among those who would stoke the muni meltdown hysteria was that nobody s talking about this, as if an almost $3 trillion market (at the time) was somehow being conducted entirely in secret and I have been a critic of how private public finance can sometimes be. Or they would claim, the experts (whoever these people were supposed to be; perhaps even I was one of them) were so conflicted that they couldn t possibly see this or that self-evident truth. The other side of the argument, of course, is that nobody was talking about it (whatever it happens to be), because it isn t true. The mainstream media, as they call it nowadays, has always had a problem with the municipal market. Municipal bonds are hard to understand. Bankers and the many financial professionals who assist public officials in their bond sales tend to follow a code of silence. The sales and trading of municipals is done over the counter, almost on a bespoke basis. The press loves a simple story, and public finance is extremely nuanced. The relatively high cost of entry for investors (you need tens of thousands of dollars to invest in munis, a few hundred to buy stocks) means that municipal bonds aren t really even part of the financial culture, in the way that stocks are. Tourists in MuniLand There wasn t a lot of what I ll call big press coverage of municipal finance because editors found the topic stupefyingly dull and so, they reasoned, few people would care to read about it. I sometimes think I would have had more readers if I wrote about Hummel figurines, or numismatics, rather than munis. Beginning in 2009, more people were claiming that the municipal market was the undiscovered country. Just look at what we ve found, these critics tourists in MuniLand would say. And, no surprise, the story they so often brought back was very similar to the stories that tourists tell: by turns frightening and amusing, and of limited long-term value. Never had so many been so misled by so few with such little actual expertise.

9 Bloomberg Brief Muni Meltdown 9 III: The End of Something The municipal market s long period of splendid isolation, if we can call it that, was all about to end. The story of the market meltdown that wasn t is very much a story of the media. To repeat: Nobody was saying that states and municipalities were not facing some pretty stiff headwinds as a result of the real estate bubble and recession. What made this time different is that house price declines played out nationally rather than, as is usual, regionally. There were of course some markets that fared much better than others, but prices fell everywhere. In April 2009, Moody s assigned a negative outlook to the U.S. Local Government Sector, saying, This is the first time we have assigned an outlook to this extremely large and diverse sector. This negative outlook reflects the significant fiscal challenges local governments face as a result of the housing market collapse, dislocations in the financial markets, and a recession that is broader and deeper than any recent downturn. Note the language: significant fiscal challenges. I had long been a fan of the restrained, sober style the analysts at the rating companies had learned to use (it was, I was informed, very much a learned style). If you were unaccustomed to the style, you could read through thousands of words of analysts prose and not quite know what they were really saying, or if they were saying anything at all. Not this time. The company continued, Sharply falling property values, contracting consumer spending, job losses, and limited credit availability lead the long list of developments that will make balancing budgets in the coming year particularly difficult. The negative outlook assigned to the U.S. local government sector encapsulates our view on this challenging environment and the strains that will be evident in credit for issuers across the industry. This was a very well-crafted, detailed piece of work in nine pages. I was impressed by the for them blunt tone as well as the way it reminded its readers that this was a big market, particular and specific to a remarkable degree, in the words of my friend Isaac. Again, Moody s: Credit pressures faced by local governments and their responses to these pressures will vary significantly across and within states due to uneven economic conditions, differing revenue mixes and service mandates, inconsistent property assessment practices, and different levels of revenue raising authority. The governance strength of individual issuers and behaviors which demonstrates their willingness and ability to adapt to that environment will determine the overall trend in individual ratings. The rating company put the entire sector on negative outlook. It didn t say that the entire sector would respond in the same way to the extraordinary, unprecedented pressures then accumulating: unemployment at more than 8 percent, stock prices off 50 percent, home prices down an average 25 percent from their peak. And what might be the result? Increased rating revisions for local governments. This was an extremely reasonable, clear piece of work from a generally recognized authority on the subject. Unhappily, because of their role in the subprime mortgage collapse, the rating companies in general had forfeited a certain credibility by this point, even in the municipal market. An earlier announcement by Moody s in March of 2007 that it would stop using a dual scale to rate municipalities and corporations had touched off a controversy that once would have dominated market conversation. Now, in the midst of the recession, it was almost an afterthought. Moody s and Fitch finally recalibrated their ratings in 2010; Standard & Poor s announced a change in its own methodology for rating municipalities soon after. Looking back at 2009, I am surprised by just what a newsy year it was in municipals. Jefferson County, Alabama, was still trying to avoid bankruptcy. Municipalities were starting to file lawsuits against those Wall Street firms that had sold them swaps and derivatives. In August, the MSRB said it was looking at flipping in the muni market, apparent in glaring fashion soon after states and municipalities started selling federallysubsidized Build America Bonds. A federal grand jury would finally indict CDR Financial Products, the firm at the red-hot center of the market s bid-rigging scandal, at the end of October. There was a time I used the expression bullets don t grow on trees from the movie Michael Collins, to characterize actual municipal market news, and to caution reporters to husband story ideas with care. No longer. In 2009, it seemed like news was breaking every day. Then one day in October, I got an from a reader. His name was familiar to me as someone who occasionally commented on my columns. He attached a report that he said he found compelling. This is the first time we have assigned an outlook to this large and diverse sector. Moody s

10 Bloomberg Brief Muni Meltdown 10 IV: Dark Vision I wish I saved that first , so I could give proper credit to the sender. In the weeks to come, more correspondents would forward me the same report, most accompanied by a message written in a tone of resignation and dismay. One even sent me a copy in the mail. People wanted to make sure I saw this thing The report was Dark Vision: The Coming Collapse of the Municipal Bond Market, published by Weeden & Co. for its clients. It was a guest perspective as they called it, by Frederick J. Sheehan. This was the first piece I had ever seen to call for the municipal market s imminent meltdown. It was also the first piece to demonstrate to me that the muni market was entering a new media age. I originally dismissed it. I glanced at that title, winced, and put it aside. Weeden & Co.? They weren t in the municipal market. Frederick J. Sheehan? Who was he? I hadn t seen him on the muni beat before. The Coming Collapse of the Municipal Bond Market? Please. It really wasn t until I spotted it again, this time in a reference to a business blog on yet another financial news web site, that I realized that the market had a problem. In the new Internet age, anyone could write anything and it could achieve the credibility and authority of publication. Anything Goes And it metastasized. An article or report was no longer published once, but again, and again, and again, all over the Internet. The new reporters, or editors, or whatever you called them, sometimes did no more than put an inviting and often sensational headline on a short summary, and then provide a link to the actual underlying document, story, report, lawsuit, opinion piece, whatever it happened to be. And then dozens or scores of readers could comment on it, further legitimizing the story, no matter how inane their own commentary. In the new Internet age, anyone could write anything, and it could achieve the credibility and authority of publication. In this publication democracy, it seemed, everything was valid, all points of view legitimate. It would take some time, for me, to realize that the key thing in this transaction was for the author to say something, usually bad, was going to occur, and very soon. This seemed to be the only criterion for the new publication world: Something Bad Is Going To Happen. This got you clicks, this got you viewers, this got you subscribers, this got you on television, and, in some cases, it got you book contracts. In fact, more often than not, in public finance as in most people s lives: Nothing happens. Things muddle along, things work out, or not, in slow and usually unspectacular fashion. Especially, might I add, in the municipal bond market, where trading in a new issue typically ceases after about 30 days, and where time is measured with a calendar. The Coming Collapse of the Municipal Bond Market? The timing of this piece was propitious. The Great Recession, it seemed, had just ended in June, but people were still ready to believe anything about everything. The Coming Collapse of the Municipal Bond Market? Why not? Hysteria Begins Dark Vision was dated Sept. 29, This is when I date the kickoff of the Muni Market Meltdown Hysteria. So many things came together at this precise moment: the rise of the Internet; the explosion of business and financial news web sites (it is worth noting that Business Insider only began in 2007); more cable business coverage; the greatest recession since the Great Depression; the 24/7 news cycle. Only a few years later, I suspect, any such meltdown call would have been mitigated, even refuted, by the very same Internet that had given birth to it. Twitter would kill it. But in 2009, most of those who knew anything about the municipal market weren t tweeting. Bond Girl, for example, didn t start tweeting until April of 2011, Reuters Muniland blogger Cate Long in July of Inexpert testimony was set for a very brief reign in the muni world. FOLLOW JOE MYSAK ON TWITTER FOR REGULAR UPDATES AND ADDITIONAL INSIGHTS

11 Bloomberg Brief Muni Meltdown 11 V: The Coming Collapse of the Municipal Bond Market Source: Bloomberg/Andrew Harrer Alan Greenspan The most remarkable part of Dark Vision was the title and subhead. For the uninitiated, Dark Vision looked plausible enough, with various bits of data and almost two pages of scholarly-looking footnotes. The more I read it and considered it, the more I realized it was little more than a series of assertions, without a lot of proof. The author had written a couple of books critical of Alan Greenspan and the Federal Reserve, according to the identifying note attached to the piece. I got the feeling, as I was reading, that he was grinding a libertarian axe. Political point of view and credit analysis usually don t mix well. I don t want to spend too much time on Dark Vision, which I found unpersuasive, so let me try and summarize. It is time to get out of municipal bonds, says Sheehan. They are now to be considered speculative investments, and buyers are just not being compensated enough for the risk they are taking. Fair enough, I thought. The municipal market will probably repeat the pattern of the sub-prime collapse, he wrote. Although it is plain to see, the usual experts do not notice. He doesn t say who these experts are, although I infer that they are the rating companies. He describes the mess in public finance: Recent cost-cutting by states and municipalities is inadequate. This much is probably obvious. What may go unrecognized is that filling these gaps using conventional measures is impossible. Parties to suffer from unconventional measures include bondholders. This pretty much sums up the Sheehan argument. States and municipalities spend too much, borrow too much, promise too much to their employees. Faced with the impossible, many municipalities will seek bankruptcy court protection. Bondholders can t rely on issuers pledges to levy taxes to pay debt service. Nor can they trust that the courts will ensure that they are paid. Had Sheehan limited his remarks to Detroit, I might have hailed him as a visionary today. Had he somehow limited his thesis to some or even a handful of municipalities, even that would have been somewhat acceptable. But no. The entire market will collapse. On the other hand, who wants to publish The Coming Collapse of an Infinitesimal Number of Municipalities? Who would read it, beside the hard core? That all states had borrowed too much was a typical canard. Taking a look at Moody s annual State Debt Medians Report published in July of 2009, the author could have seen that net tax-supported debt per capita drops fairly quickly after you look at the top 10 states. In first place was Connecticut, at $4,490; in 10th was California, at $1,805. In 30 of the states, the figure was below $1,000. A similar story could be told about public pensions, as well as public employee pay. A few states were bad at making their actuarially-required contributions to their pension systems. Some states and cities had sweetened pensions, and salaries, without much apparent regard of how to pay for them. And then there were some errors: Current bond issues will need to be rolled over when they mature, since budget gaps are rising. Sheehan takes a hallmark of the sovereign debt market and transfers it to munis. That s not how munis work. Municipalities pay off their debts over time, usually through the use of serially maturing bonds. Yet this rollover error would be repeated. Note here that Sheehan wasn t talking about the letters of credit or liquidity facilities backing variable-rate demand obligations expiring. This would become one of the market s typical non-issue issues in 2010 and As it turned out, the market handled the, in Moody s words, unprecedented number of expirations handily. Sheehan wasn t talking about VRDOs. He was describing the next Greece, as critics of the time put it. One of the largest municipal expenditures is coupon interest on bond obligations. That s not true. Debt service is actually one of the smaller items in most municipal budgets. As analysts would eventually point out, why would public officials go out of their way to anger the investors they need and target debt service, since it would be of so little help in a financial emergency? Why did I go back and read Dark Vision? Because more than a month after it was published, it was mentioned on a business news web site, which linked to a piece on the Seeking Alpha blog, which in turn linked to a piece on a Harvard Law School blog, picking up approving comments from the uninformed every step of the way. And so the coming collapse of the municipal bond market had been announced. In 2011, Bloomberg Brief: Municipal Market s Brian Chappatta asked Sheehan what happened why hadn t the market collapsed? He gave a very detailed response, which I include here as Appendix 2. I called him on Nov. 17 of this year, and he gave me a very similar response: One thing I didn t understand was how hard states would work to pay their bonds so they could continue to legislate. I thought there d be much more of a battle between paying bonds and other expenses like pensions. I still think that has to come at some point, as the asset price bubble starts to deflate. [States and municipalities] have continued to spend as if they learned nothing from how close they did come to defaulting in 2009.

12 Bloomberg Brief Muni Meltdown 12 VI: Into The Abyss The crush of news in 2009 meant that it took a while for the market to confront the municipal bond meltdown scenario being presented. The Sheehan piece achieved what I sensed was wide circulation, showing up around the Internet without much in the way of rebuttal. Sheehan was first. James Chanos, noted short-seller, appeared in Barron s in the Nov. 9 Current Yield column: Dump Munis, was the headline. The culprit: platinum-plated health-care and retirement benefits, said Chanos. I asked Chanos on Nov. 17 if he had any further thoughts about the municipal market, and he declined comment. On Dec. 16, 2009, Standard & Poor s published a paper entitled Credit FAQ: The Recession s Impact on U.S. State and Local Government Credit Risk. I now see this as the first defense of munis. Whether it was done in response to Sheehan, I do not know. The FAQ format is, of course, a feature of the Internet; I m not sure how much circulation this piece got. It was detailed and reasonable and accurate. But of course Collapse trumps Muddle Along in the Internet popularity stakes. My favorite answer came in response to the question: Then why do state and local governments keep talking about the dire straits they are in? S&P said: As this all plays out, we think that new headlines will likely capture elected officials and others efforts to make the public aware of the circumstances of their austerity measures and what they think will be the consequences of inaction. Do the Right Thing The important thing about the S&P piece, as well as the earlier Moody s commentary tagging the entire sector with a negative outlook, was that both rating companies expected most public officials to do the right thing by their bondholders. Also noteworthy, especially in retrospect, is how S&P took pains to say how conditions do vary. Once again: particular and specific. It s very much like that old legal expression: all facts and circumstances. Even in 2009, you could see several themes playing out here. On the one hand, you had outside critics saying that municipalities were all in the same boat, that they had exhausted their resources, and that default and repudiation were inevitable. On the other, you had analysts saying that it was impossible to generalize about issuers, that most of them had plenty of resources still available to them, and that most of them could actively manage their way out of the situation. The final piece of the puzzle appeared at the very end of the year, although it didn t gain traction until later: a white paper by Joshua D. Rauh of the Kellogg School of Management at Northwestern University: Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities. Title of paper by Joshua Rauh, Kellogg School of Management at Northwestern University Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities. Of course, we all know what the answer to the title s question was. This was a provocative piece of work. Up to this point, as far as I know, nobody had predicted that pension funds would run out of cash altogether, or that pension underfunding might drive states to insolvency, as Rauh claimed. Rauh also introduced his notion that state and local pension plans should discount the benefit cash flows at Treasury rates. In other words, they should stop assuming that the assets they had put in their pension systems would produce 8 percent a year. Discounting benefit flows at Treasury rates produced a gap between assets and liabilities of $3 trillion at the end of 2008, Rauh wrote. He also modeled which states plans would run out of money, and when. Rauh s chief assumption was that states would contribute enough money to their pension plans to fully fund newly accrued or recognized benefits at state-chosen discount rates (usually 8 percent) but no more. This was broadly in keeping with states recent behavior. The paper itself was no easy read, but the Table 1: When Might State Pension Funds Run Dry? was clear enough. Rauh predicted that Illinois would run out in 2018, Connecticut, Indiana and New Jersey in 2019, Hawaii, Louisiana and Oklahoma in Alaska, Florida, Nevada, New York and North Carolina would never run out. Rauh is now at the Stanford Graduate School of Business. He didn t respond to a request for comment. He has continued to publish, and his views are now wellknown. It used to be that public pension funding was one of those things covered by rating companies perhaps on a quarterly basis. Now, it seems that we get regular, detailed updates on their condition almost weekly. This is a good thing. People didn t really start to discuss the Rauh study until This would prove to be the cauldron year for the muni meltdown.

13 Bloomberg Brief Muni Meltdown 13 VII: Public Pensions The year 2010 was the peak year for meltdown mongering. It was as if with the real estate bubble burst, banks failing and companies from auto manufacturers to Wall Street brokerages in bankruptcy, gloomsters could finally turn their attention to states and municipalities. Not all the material being published about public finance was incendiary. Some was salutary. As the old saying goes, never waste a crisis. So it was with public pensions. In February, the Pew Center on the States published The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform, a thoughtful, comprehensive 61- page study. Pew said the difference between what states had on hand and the pension and other retirement benefits they had promised amounted to $1 trillion, and that was conservative, because it was based on June, 2008, data and thus hadn t taken into account all investment losses. The Pew report was unhysterical and exhaustive, filled with maps and tables of data. It showed the extent of investment losses, and ranked how the states were managing the situation. On pensions, it said, 16 were solid performers, 15 needed improvement and 19 were serious concerns, while in the area of health care and other benefits, which most states had treated as a pay as you go expense, 9 were solid performers in terms of quantifying the obligation and putting aside money for it. The report also noted that 15 states in 2009 had passed legislation reforming some aspect of their pension systems, usually by making new employees contribute more. As if any reminder were needed, the results showed how the subject of public pensions resisted generalization. New York s pensions were 107 percent funded, Florida s 101 percent. Illinois had only 54 percent of the money it needed, Kansas 59 percent, Colorado, 70 percent. The study also examined investment return assumptions, just then becoming a fat target for critics. Recall that in September 2009, Pimco s Bill Gross coined the term the New Normal to characterize the low-growth, low-yield future. The Carolinas calculated they would earn 7.25 percent, Colorado, Connecticut, Illinois, Minnesota and New Hampshire 8.50 percent. By far the most states, 22, were at 8 percent, which, as the report pointed out, was the median investment return for pension plans over 20 years. The report examined the factors that contributed to the $1 trillion gap, such as the volatility of investments, states failing to make their annual actuarially-required contributions and ill-considered benefit increases during good times. It also examined the road to reform. Of course the Internet focused on the $1 trillion gap, and even more on the Rauh $3 trillion gap. A subject that had received scant attention except among the rating companies, municipal analysts, some local newspapers, and the blog that since 2004 collected coverage of the topic, was now in the spotlight. Public pension analysis was, almost, the flavor du jour. At least three more academic reports on public pension liabilities were published during the year. Distinct Risk to Taxpayers In April, the American Enterprise Institute for Public Policy Research presented resident scholar Andrew Biggs s The Market Value of Public-Sector Pension Deficits, basically an endorsement of the Rauh $3 trillion pension gap figure. Then in June came a working paper by Eileen Norcross and Andrew Biggs, published by the Mercatus Center at George Mason University entitled The Crisis in Public Sector Pension Plans: A Blueprint for Reform in New Jersey. Norcross and Biggs repeated the Rauh $3 trillion gap and advocated defined contribution over defined benefit pension plans. The latter, they said, presented a distinct fiscal risk to taxpayers. And in October, Rauh and Robert Novy-Marx of the University of Rochester produced a paper, The Crisis in Local Government Pensions in the United States for a conference on retirement and institutional money management post-financial crisis. The authors looked Source: Bloomberg/Andrew Harrer The New Normal : Bill Gross at the unfunded pension obligations of local governments, and concluded that, if already-promised benefits were discounted at riskless, zero-coupon Treasury yields, the total unfunded obligation for the municipalities they studied was $383 billion rather than the $190 billion the localities themselves calculated. I was of two minds about the explosion of interest in public pensions. On the one hand, I thought it good to focus on the subject, because it seemed that certain of our elected representatives over time had sweetened the salary and public pension pot in exchange for union peace and votes, with no consideration for the way even little enhancements add up. They also all too often neglected to keep up with their actuarially-required contributions to their pension plans. On the other hand, I objected to the crisis terminology which made it seem to the uninitiated as if states and localities had to come up with the money to fill the gaps overnight. As always, I worried that generalizing about the subject was distracting. What we really needed was focus: Which states and municipalities had done the worst jobs managing public pensions? More importantly, why? These things aren t easy to trace, but glossing over the subject in favor of big numbers lets the guilty parties off the hook. What hapcontinued on next page...

14 Bloomberg Brief Muni Meltdown 14 continued from previous page... It had taken almost three decades, and the dawn of the Internet age, for me to realize that data was not definitive, that analysts could make the numbers dance. pened, when, why, and how can we guard against it happening again? Amplified Alarm I think it was around this time, too, that I became very skeptical of all studies and reports. It had taken almost three decades, and the dawn of the Internet age, for me to realize that data was not definitive, that analysts could make the numbers dance. I also began growing impatient with what I came to call the media s denominator problem. Such-and-such costs $3 BILLION dollars, radio and television announcers would declare, all but reaching a full windup to deliver the plosive BIL- LION. And that was fine. But it matters a great deal if the $1 BILLION is part of a budget, say, of $5 billion, or part of one amounting to $50 billion or $150 billion. We emphasize the numerator and ignore, if we even know, the denominator. In March, the National Association of State Retirement Administrators released two short but meaty reads, the first on public pension plan investment return assumptions, the second an analysis of the Rauh paper. Both attempted to reassure readers that there was a basis in fact for investment return assumptions: Over a 20-year period, median annualized investment returns were 8.1 percent; over 25 years, 9.3 percent. In other words, the 8 percent return assumptions prevalent among public pensions weren t fictional. The analysis of the Rauh paper, Are State Public Pensions Sustainable? said that the author ignored incremental changes being made to improve the longterm sustainability of public pensions, and that his central assumption, that states would make contributions sufficient to fund newly accrued or recognized benefits but no more, was unsupported by current practice. There was, it appeared, another side of the story. How many Internet commenters read it, I have no idea. Who cared about the facts when alarm and exaggeration could be echoed and amplified? BloomBerg Brief group SuBScriptionS Bloomberg newsletters are now available for group purchase at very affordable rates. Share with your team, firm or clients. contact us for more information:

15 Bloomberg Brief Muni Meltdown 15 BLOOMBERG RANKINGS Most Underfunded Pension Plans: States RANK STATE FUNDING RATIO 2013 % FUNDING RATIO 2012 % FUNDING RATIO 2011 % FUNDING RATIO 2010 & FUNDING RATIO 2009 % FUNDING RATIO 2008 % MEDIAN % 1 Illinois Kentucky Connecticut Alaska Kansas New Hampshire Mississippi Louisiana Hawaii Massachusetts North Dakota Rhode Island Michigan Colorado West Virginia Pennsylvania New Jersey Indiana Maryland South Carolina Virginia Alabama Oklahoma New Mexico Vermont Nevada Ohio Montana Arizona Arkansas Minnesota Utah Missouri California Wyoming Nebraska Maine Texas Georgia Iowa Florida Idaho New York Delaware Oregon Tennessee Washington North Carolina South Dakota Wisconsin Median For the fourth year in a row, Illinois, Kentucky and Connecticut top the list of most underfunded pension plans METHODOLOGY: Bloomberg ranked U.S. states based on their pension funding ratios in The Bloomberg municipal data and municipal fundamentals teams collected and supplemented data from each state s Comprehensive Annual Financial Report, a set of government financial statements. Data are for individual states respective fiscal year-ends as of the date of publication of the CAFR. Supplemental pension reports intended to augment a particular year s CAFR were added to that year s fundamentals. Fiscal year-end of supplemental pension reports may differ from the state s CAFR. All other reports were carried forward to the next fiscal year. The funding ratio provides an indication of the financial resources available to meet current and future pension obligations. Percentages were calculated by dividing the actuarial value of plan assets by the projected benefit obligation. Where specific data were missing in the consolidated reported totals, the pension funds were contacted directly. The District of Columbia had a funding ratio of 103.6% in Source: Bloomberg AS OF: October 2, 2014

16 Bloomberg Brief Muni Meltdown 16 VIII: Media Frenzy Source: Svein Erik Dahl/John Wiley & Sons Christopher Whalen It wasn t long before it seemed like everyone was talking about a Muni Meltdown. The following is a by no means exhaustive list of some of the alarming stuff published on munis in I m not including the bloggers who at this point were advocating defaulting on bonds on behalf of the taxpayers or clickbait compilations like The 10 Cities That Will NEVER Come Back that were such a favorite of Business Insider at the time. I should note here that Joe Weisenthal, then of Business Insider, now works for Bloomberg as Digital Content Officer. Consider this, from the newspaper of record: California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes and armies of retired public workers who are counting on benefits that are proving harder and harder to pay. Greek Myths The story appeared on Page One of the March 30 New York Times, headlined, State Debt Woes Grow Too Big to Camouflage. Reporter Mary Williams Walsh continued, Some economists fear the states have a potentially bigger problem than their recession-induced budget woes. If investors become reluctant to buy the states debt, the result could be a credit squeeze, not entirely different from the financial markets in Europe, where markets were reluctant to refinance billions in Greek debt. Then there was the April blog posting by Rick Bookstaber, a senior policy adviser at the SEC. The next big crisis was the municipal market, he wrote. The culprit: overleverage, in the form of high pension benefits and post-retirement health care. He observed: Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred by a taxpayer revolt democracy at work. Bookstaber was among those asked by Brian Chappatta at the end of 2011 about what happened. His response is contained in Appendix 2. I chatted with Bookstaber, who now works for the U.S. Treasury in the Office of Financial Research, in mid- November, and he told me he had nothing to do with the muni market, and declined further comment. I knew we had reached an entirely different level of muni crisis coverage when Matt Taibbi of Rolling Stone, who had achieved a certain notoriety in 2009 when he likened Goldman Sachs to a giant vampire squid wrapped around the face of humanity, weighed in with an article entitled Looting Main Street in the April 15 edition of the magazine. The Taibbi piece concerned Jefferson County, Alabama s use of interest-rate swaps, and was subtitled, How the nation s biggest banks are ripping off American cities with the same predatory deals that brought down Greece. The message was that municipalities were now reeling under the weight of similarly elaborate and ill-advised swaps, which the author termed a financial time bomb. It had been quite a few years since I had read Rolling Stone. I ve been pretty exercised about municipalities use of swaps, myself. I m not sure how many Americans get their investing advice from Rolling Stone, but they couldn t have found comfort in yet another tale of predatory Wall Street and feckless or corrupt public officials. The right-leaning Manhattan Institute s Nicole Gelinas in the think-tank s City Journal advised readers of the Spring 2010 issue to Beware the Muni-Bond Bubble. Gelinas wrote: Investors in municipal bonds don t have to worry about a thing, the thinking goes, because the states and cities that issue them will do anything to avoid reneging on their obligations and even if they fail, surely Washington will step in and save investors from big losses. She continued: These are dangerous assumptions. Just as with mortgages, the very fact that investors place unlimited faith in a market could eventually destroy that market. If investors believe that they take no risk, they will lend states and cities far too much so much that these borrowers won t be able to repay their obligations while maintaining a reasonable level of public services. The investors, then, could help bankrupt state and local governments and take massive losses in the process. Interesting Point of View This was, I thought, an interesting point of view. And then: The uncomfortable truth is that as municipal debt grows, the risk mounts that someday it will be politically, economically, and financially worthwhile for borrowers to escape it, Gelinas wrote. Four years on, I asked Gelinas about the relative resilience of the market. In an e- mail dated Nov. 16, she replied, The resilency is shallow. Pension funds are doing well because [of] the Fed s extraordinary actions to push up asset prices. But around the nation, from state-level credits such as Illinois and New Jersey to rich cities like New York to poorer and smaller cities and towns all over the place, many places are still pretty much insolvent, she wrote. They cannot make good on the healthcare promises they have made to current and future retirees, and many will not be able to make good on their promises to pensioners. In the meanwhile, infrastructure deteriorates because money that should be going to the future is going to the past. The 2009 recovery act was a missed opportunity to help states, cities, and other municipal credits fix their longterm structural problems, mostly pensions and health promises, in return for immedicontinued on next page...

17 Bloomberg Brief Muni Meltdown 17 Seeking Refuge Whitney at the time said she had spent two years working on the report, which didn t predict any state defaults. Yet she began making the rounds, appearing on business radio and television and warning about how overleveraged states were, and how they needed a federal bailout. In the Nov. 3, 2010 Wall Street Journal, she wrote an OpEd piece entitled, State Bailouts? They ve Already Begun. On Oct. 5, the New York Times s Mary Williams Walsh wrote about how Harriscontinued from previous page... ate cash; instead, Washington treated it as a cyclical revenue shortfall. She continued, That we haven t seen bondholder panic is more a sign of the desperation for yield and the principalagent problem (do retail investors really know the risks that they are taking or do they see bonds as safe ). It s harder today than it was five years ago to assess the too-big-to-fail risk that is, it is unclear whether Washington would step in to save, say, Citigroup bondholders, this time around, and it is similarly unclear whether Washington would step in to save, say, Illinois or New Jersey bondholders or pensioners. In the end, the clearest action that Congress takes may or may not be in not bailing out Puerto Rican bondholders. Warren Buffett opined on the muni market at least twice in 2010, telling shareholders at the Berkshire Hathaway annual meeting in May, It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they ve gone to General Motors and other entities and saved them. In June, Buffett appeared before the U.S. Financial Crisis Inquiry Commission and predicted a terrible problem for municipal bonds and then the question becomes will the federal government help. Buffett hasn t moderated in his views. In the Feb. 28, 2014 letter to Berkshire shreholders, he wrote: Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn t afford. Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made that conflicted with a willingness to fund them. On June 14 of 2010, Ianthe Jeanne Dugan wrote in the Wall Street Journal that investors were ignoring warning signs in the municipal market. The article was headlined, Investors Looking Past Red Flags in Muni Market. James Grant a friend, for whom I worked from 1994 to 1999 offered another take on repudiation in the June 25 Grant s Interest Rate Observer, in a scholarly article headlined, Concerning the American Repudiation Gene. So low are yields, so complacent are investors, so persistent are fiscal deficits, so heavy is the weight of post-retirement employee benefits and so ill-equipped are mutual funds to deal with anything resembling a shareholders run that we are prepared to take the analytical leap. On the length and breadth of the muni market, we declare ourselves bearish, wrote Grant. The repudiation gene is ever present, Grant continued, well into a very scholarly article. The question is whether circumstances in the tax-exempt market may coax it out of latency and back into action. I asked Jim about his call this year. On Nov. 17, he ed: A swing and a miss. Source: Bloomberg/Ramin Talaie American Repudiation Gene : James Grant The muni market has continued to mosey, there was no run on mutual funds. Perhaps more to the point, there turned out to be no homogeneous market on which to be comprehensively bearish. What s Paul Isaac s line? Grant continued: As to surprises: Where we erred was in expecting surprises. The muni market has not surprised. No drama, no short-selling, no credit upheaval, no volatility to speak of. He concluded: As to the current Grant s stance toward munis, we judge that yields are too low. In that they resemble yields nearly everywhere. A Muni-Bond Bomb On Aug. 23, Steve Malanga of the Manhattan Institute wrote an OpEd piece in the Wall Street Journal about the SEC charging the state of New Jersey with fraud for misleading investors; the article was entitled, How States Hide Their Budget Deficits, and implied that other states may be guilty of the same thing. Malanga also had a story in the Summer 2010 edition of City Journal, How to Dismantle a Muni-Bond Bomb. He wrote: State and local borrowing, once thought of as a way to finance essential infrastructure, has mutated into a source of constant abuse. Like homeowners before the housing bubble burst, states and cities have gorged on debt, extended repayment times, and used devious means to avoid limits on borrowing all in order to finance risky projects and kick fiscal problems down the road. He offered a handful of reforms, and said if the state and local debt bomb can t be defused, we re all at risk. I chatted with Malanga about the lack of a muni explosion since then in mid- November of this year. He noted that rating companies were now putting much more weight to pension debt in assessing credit, and, What we re seeing is a little more skepticism in the marketplace because of what happened in Detroit. He added, It s a very uncertain time for the municipal market. In September, Meredith Whitney produced The Tragedy of the Commons, a report on the 15 largest states. This would have gotten a lot splashier coverage when it appeared had Whitney actually published it. As it was, she sent out a press release, but refused to show it to anyone but clients. I asked for a copy and was told I d have to pay for it. continued on next page...

18 Bloomberg Brief Muni Meltdown 18 continued from previous page... State and local borrowing, once thought of as a way to finance essential infrastructure, has mutated into a source of constant abuse. Steven Malanga, the Manhattan Institute burg, Pennsylvania, was seeking to enter the state s Act 47 distressed-cities program, in a story headlined Cities in Debt Turn to States, Adding Strain. She wrote Across the country, a growing number of towns, cities and other local governments are seeking refuge in similar havens that many states provide as alternative to federal bankruptcy court. The Wall Street Journal led its Money and Investing section on Oct. 10 with New Risks Emerge in Munis: Debtholders Are Left Steamed as Some Cities Forgo Repayment Promises. The story detailed Menasha, Wisconsin s, failure to make an appropriation to pay debt service on a failed steam plant. CALIFORNIA WILL DEFAULT ON ITS DEBT screamed the Business Insider headline on a Nov. 16, 2010, story about bank analyst Chris Whalen s appearance on TechTicker. Henry Blodget wrote: He says there s no bailout coming for California or, for that matter, any of the other bankrupt states. And that means big losses for muni-bond holders... On the Brink Nicole Gelinas offered a prescription for Congress to aid states, in a Nov. 17 New York Post piece, States on the Brink. In it she quoted Felix Rohatyn, the banker who helped craft New York City s rescue in 1975, who earlier that month told Charlie Rose, We are facing bankruptcy on the part of practically every state and local government. Even Gelinas thought Rohatyn overstates the case today. She advised Washington to get ready to bail out states: municipal market turmoil could prove contagious. The Weekly Standard s cover story on Nov. 29 was Give States a Way to Go Bankrupt, by University of Pennsylvania law professor David Skeel. He suggested that both California and Illinois might avail themselves of such a law. Skeel didn t return a call for comment. His views on Chapter 9 municipal bankruptcy seem not to have changed at all. In August, he wrote a piece for the Wall Street Journal, approving Puerto Rico s new law allowing certain public corporations to restructure their debt. If Puerto Rico can restructure its debt, he wrote, there could be hope for states particularly Illinois whose own finances are sketchy. He continues to advocate a federal bankruptcy law covering the states. The lead story in the Dec. 5 Sunday New York Times was Mounting Debts by States Stoke Fears of Crisis by Mary Williams Walsh. And on Dec. 7, then-business Insider s Joe Weisenthal wrote about a Facebook post by Sarah Palin: Sarah Palin Knows Where The Next Battle Is, As She Blasts The Idea of Bailing Out States. Palin wrote: American taxpayers should not be expected to bail out wasteful state governments. Fiscally liberal states spent years running away from the hard decisions that could have put their finances on a more solid footing. Now, you might well ask what kind of stories Bloomberg News was running at this time. Among the stories filed by the States & Municipalities team were Moody s Muni Bond Ratings Will Move to Global Scale, U.S. States Expect Taxes to Rise After Facing $84 Billion Gaps, and Wall Street Takes $4 Billion From Taxpayers as Swaps Backfire, this last an investigative piece quantifying how much in swap termination fees municipal issuers had paid to banks since And then on Sunday evening, Dec. 19, 60 Minutes ran a segment entitled State Budgets: The Day of Reckoning. REAL ESTATE THIRD QUARTER 2014 CLICK HERE

19 Bloomberg Brief Muni Meltdown 19 IX: The Market Responds to Its Critics Before we turn to the events of Sunday, December 19, a day that will live in municipal market infamy, let s briefly consider some of the stuff that was published and subsequently rattled around on the Internet, and the market s response to it. The articles that appeared in 2010 were generally long on headline, short on specifics. They shared a common theme: Something terrible is going to happen. And that is: States and municipalities are going to default on their bonds, because they are all being overwhelmed by debt and pension obligations. Most of the stories contained no fine shading, no nuance, and, unless the various articles described exceptional incidents that were already well-known and previously-reported Harrisburg, Jefferson County, the Menasha, Wisconsin steam plant, Vallejo s bankruptcy, various silly economic development, stadium and convention center financings there was very little that was new. Beyond this rather large generalization: California, Illinois and New York, staggering along under seeming mountains of debt, are all going to go bust. Missing Detroit I suppose if you had wanted to look at things nobody was talking about back then, nobody was talking about Detroit staggering along toward an eventual bankrutpcy filing in 2013, or that Puerto Rico had its own crushing mountains of debt, or that Jefferson County, Alabama, would file for bankruptcy in 2011 or that Stockton, California, would file in That would have all been very useful, but it also would have required a lot of digging and a ton of luck. Along with predicting that Michigan Governor Rick Snyder would specifically authorize Detroit to file for Chapter 9. The articles that appeared in 2010 almost all seemed intent on proving the market wrong, but only by way of innuendo. Most of the authors were confounded by the lack of movement in what they called prices, although what they usually referred to was one or another of various yield indexes rather than actual trading. That s because most bonds only trade Tom Kozlik for the first 30 days after being sold. So when someone writes, for example, the municipal market tanked, I want to ask: How do you know? That s an equity mindset. What really happens is: The bid-side dried up. It s not as though you can go someplace and say, Okay, I d like to buy all the cheap munis now. Finally, some of the provocative material that was published in 2010 was frankly political, aimed at public-employee labor unions, now fingered as the culprits behind massive state and local pension liabilities. Their 401(k) accounts and retirement dreams now in shambles, many Americans were prepared to indulge in pension-envy. The municipal bond industry reacted slowly and thoughtfully to the hysteria. By the fall of the year, though, the industry had produced a number of solid, comprehensible reports spelling out, basically, That s Not How This Market Works. One of the first responders was Tom Kozlik, a municipal credit analyst at Janney Montgomery Scott in Philadelphia. In the firm s July 14, 2010, Municipal Bond Market Monthly, Kozlik wrote, Many stories published of late in the popular press have included overblown perspectives of municipal market risk. His piece was entitled, Municipal Market Myths and Truths and Veritas Vos Liberabit Which Means, The Truth Shall Set You Free. He discussed headline risk, and observed, Although recent articles in the popular press try to portray a balanced opinion about the status of the municipal market, too often writers and commentators are not relying on municipal market experts for facts about the realities stressing the municipal market. He continued, The confusion, lack of knowledge and resulting fear mongering we have seen in the print and televised media has occurred because continued on next page... The confusion, lack of knowledge and resulting fear mongering we have seen in the print and televised media has occurred because of the media s misunderstanding of the municipal market. Tom Kozlik, municipal credit analyst at Janney Montgomery Scott

20 Bloomberg Brief Muni Meltdown 20 continued from previous page... Source: Bloomberg/Jin Lee Tragedy of the Commons : Meredith Whitney of the media s misunderstanding of the municipal market. The myths Kozlik addressed: That there was going to be a Municipal Meltdown or a percentage of defaults or municipal bankruptcies significantly above the historical norm; that the market would crash like the sub-prime loan market; that there would somehow be a default or bankruptcy contagion effect; that California, Illinois, or New Jersey would be the next Greece; that ratings and bond insurance were worthless. I m not sure how many reporters or commentators saw Kozlik s piece, or the various other rejoinders that started to appear thereafter. Maybe some of this material got through and was disregarded because it didn t fit the narrative, or was dismissed because the writers felt the analysts involved were somehow discredited. So much of what I thought passed for dialogue in those days was, after all, privately disseminated. Reporters only received some of it. Most U.S. states are lightly indebted compared with regional governments elsewhere in the world. Gabriel Petek, Standard & Poor s People Unfamiliar As Kozlik wrote in a retrospective piece on Aug. 27 of this year, Several reporters were dead set on the idea that the municipal market was the next sub-prime market and the municipal market would melt-down. Most of the stories stoking the hysteria about munis featured quotes by, as I would characterize them now, people unfamiliar. The go-to guy for the insider s point of view, someone who actually knew what he was talking about and wasn t afraid of being quoted, was Matt Fabian of the research firm Municipal Market Advisors. He was the Voice of Reason, the To Be Sure source in a sea of inexpert testimony. He must have been a very busy man. In some ways, I performed a similar role briefly in 1995, after Orange County, California, went bust. You can look it up. On Sept. 30, 2010, Fabian produced a one-sheet Special Report on Vilifying State Creditworthiness, a sort-of response to Meredith Whitney s Tragedy of the Commons, which he admitted he had not seen yet. After acknowledging the report might have some salutary effect in regard to budget-cutting, pension-building, debt-deferral and increased disclosure, Fabian wrote: We are reluctant to directly rebut the report without having the document itself. However, based on media coverage, it appears to succumb to what has been a common problem of non-municipal observers of our market: the conflation of various state stakeholder exposures. Misunderstood Leverage States are unlikely to default on their bonded debt, he said, because of a number of legal protections. What meltdown proponents were predicting was a mass, anarchic, political and legal abdication. He also addressed rollover risk, first broached by Frederick Sheehan the previous year in his Dark Vision. Remember, wrote Fabian, that leverage is an often misunderstood term. While states have greatly increased debt borrowings over the last five years, essentially all outstanding municipal debt is self-amortizing. Meaning, similar to a residential mortgage, principal is paid down regularly via level annual debt service payments funded with tax receipts. He continued: Municipal issuers do not borrow as do international sovereigns or the US treasury: via large short maturity notes that in practice can only be refinanced with more debt, creating a crippling reliance on market acceptance for solvency. As we saw in 4Q08, an extended primary market closure produced no knock-on defaults; states simply stopped funding new infrastructure until rates fell far enough to justify the cost. John Hallacy, head of municipal research at the then-new combination, Bank of America Merrill Lynch, confronted Apocalypse Muni in a comment piece on Oct. 1. He acknowledged that the federal government had already assisted the states: The ARRA or stimulus provided several different levels of assistance including extending Unemployment Insurance benefits. Additional legislation in the amount of $26 billion was approved to provide extension of a higher level of Medicaid reimbursements for two quarters in the amount of $16 billion, and additional education assistance with the remaining $10 billion. Hallacy also noted, Debt and the amount of leverage on the part of the issuer have never been the best predictors of creditworthiness, and observed: continued on next page...

21 Bloomberg Brief Muni Meltdown 21 continued from previous page... The ratio that matters the most to us is the debt service carry on the budget. Most issuers keep this ratio well within 10 percent, and the level is typically closer to 5 percent. If the debt service carry is over 10 percent, the reason is most often because said issuer prefers to amortize its debt on a more rapid schedule. So maligned had the asset class become by this time that Hallacy added at the end of his piece, We are not apologists for the Municipal Market. Moody s on Oct. 5 published a Special Comment, Why US States Are Better Credit Risks Than Almost All US Corporates. The Comment described Illinois, at the time the lowest-rated state at A1, and then detailed why all of the states, even Illinois, were of better credit quality than 96 percent of corporate borrowers. Munis Not Corporates Fundamental strengths of states, according to Moody s, include the capacity to increase revenue by taxes; the ability to cut expenses and capital outlays without reducing revenue; strong legal protection for debt service payments; limited consequences to running deficits and accumulating negative balances; less competitive pressure; lower event risk; and potential federal support. This was probably one of the more important pieces produced during the crisis, describing as it did the unique characteristics of states (and, by extension, municipalities) compared to companies. People unfamiliar have long confused the equity and municipal markets, in the way they trade and in the way they respond to bad news. It is little wonder, then, that they also likened municipal issuers to companies. In fact, as Moody s pointed out, Game Over looms over companies much more closely than it does over states and municipalities. On Nov. 8, Gabriel Petek of Standard & Poor s published two reports: U.S. States Financial Health and Debt Compare Favorably With Other Regions and U.S. States and Municipalities Face Crises More of Policy Than Debt. In the first, S&P reminded readers that, From a global perspective, most U.S. states are lightly indebted compared with regional governments elsewhere in the world. In our opinion, various constitutional or legal requirements for balanced budgets more unusual outside the U.S. have kept U.S. states debt burdens at moderate levels. The report compared Ontario, Bavaria, Basel, Texas, New York, Illinois and California, and concluded, in our assessment of U.S. states creditworthiness, we consider debt service payments to be a very modest proportion of expenditures and admit that most administrators are able to manage through severe economic turbulence, due in part to their relative lack of leverage. We believe that some discussions about financial catastrophe are meaningful only if governments prove unwilling to use their powers of adjustment to manage their positions. Source: Bloomberg/Jennifer S. Altman Bold prediction! Don t back down now! : Henry Blodget Economic Engines The analysis included a table of various financial measures and showed how states stacked up pretty favorably, especially in terms of revenue. California and New York in particular are economic engines. The larger piece emphasized state and local government agency. That is, these governments have the ability to manage their way out of financial crises, and Standard & Poor s expected them to do so: We believe the crises that many state and local administrators find themselves in are policy crises rather than questions of governments continued ability to exist and function. They re more about tough decisions than potential defaults. The report stated that debt service is usually a payment priority, a legal obligation, and then considered California, Illinois, New York and Texas, as well as a number of localities, including Las Vegas and Detroit. From our perspective today, perhaps Detroit is the most interesting of the bunch. The rating company was unequivocal: Michigan has repeatedly indicated to Standard & Poor s that it would take all steps necessary to prevent a[n emergency financial] manager from filing for bankruptcy protection. Fitch offered a Frequently Asked Questions written by lead analyst Richard Raphael called U.S. State and Local Government Bond Credit Quality: More Sparks Than Fire on Nov. 16. I liked it because it was full of common sense and treated the subject in straight English, and reiterated the strengths of the market: Due to the 20- to 30-year principal amortization of debt that is common in the U.S. municipal market, large bullet maturities and consequent refinancing risk is limited, and Debt service is a relatively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action), for example. And then the company treated systemic risk, or the chance that the entire market would melt down somehow: The municipal bond market is diverse, with thousands of issuers, over a dozen distinct sectors, and multiple security structures. The legal framework for municipal bonds depends upon a multitude of constitutional, statutory, local ordinance, and contractual provisions. Each municipal bond sector has unique criteria and risks. Further, in many cases, a single municipality will issue several series of bonds, each secured by a different type of security. I think the two pieces I enjoyed most emanated not from the industry but from the media itself. On Nov. 22, Brett continued on next page...

22 Bloomberg Brief Muni Meltdown 22 continued from previous page... Arends of MarketWatch responded to the Christopher Whalen California Will Default interview with Henry Blodget the previous week. Can everyone please stop talking total nonsense about the California budget? wrote Arends. I know that facts and truth seem to be optional these days. I know that in the exciting new world of infinite media everyone can choose to believe whatever fantasies they want. But in the case of California, it s getting on my nerves. Arends recounted an exchange he had with Whalen, who said My general comments have to do with my guess as to the impact of mounting foreclosures and flat to down GDP on state revenues. All Henry s Fault Arends replied, Your guess? These are important problems, to be sure. But do you have any actual numbers? To which Whalen replied, Revenues fall and mandates rise to the sky. You do the math. Arends pressed: Er, no, actually, it s your assertion. You do the math. Whalen finally blamed Blodget. I am a bank analyst. I have not written anything on this. My comments have taken on a life all their own. This is all Henry s fault. Call him. Some prediction, Arends wrote, and then: Meanwhile Blodget chimed in on the exchange: It s a bold prediction! Don t back down now! Arends concluded: Bah. Welcome to the media world in He then produced a piece showing that California, far from being the Greece of America, was actually the Germany of America, an economic powerhouse with a high standard of living, where entrepreneurs still wanted to do business and one of the states that sent far more money to Washington than Washington redistributed. It didn t end there. On Nov. 23, Felix Salmon wrote about the incident for the Columbia Journalism Review s The Audit blog, which discusses financial journalism: In reality, what we re seeing here is expertise mission creep, and a rare example of an expert admitting to it. Whalen s company is highly regarded when it comes to analyzing banks balance sheets, and as a consequence of that regard, Whalen has gotten for himself a nice perch in the punditosphere, as well as a new book. But Whalen, as he admitted to Arends, is no more an expert on municipal finance than Freeman Dyson is on global warming. And so the proper stance for Blodget to take was not to deferentially pose questions to Whalen and then passively receive his oracular words of wisdom, but rather to push back and have a proper debate about Whalen s assertions, as Arends might have done. This was the clincher for me, though: More generally, the municipal bond market is a very complicated place, where expertise is hard-earned and voluble new entrants are inherently mistrusted, normally for good reasons. Whalen, now a Senior Managing Director at Kroll Bond Rating Agency,was one of those interviewed by Brian Chappatta at the end of 2011 about the lack (so far) of a Muni Meltdown, and his comments lead off Appendix 2. I also ed him on a recent Sunday to ask him about it. On Nov. 16, he ed: The process has proceeded about as I thought. Cases like Detroit and Stockton, CA, are the extreme examples where default has occurred, but in general the political class has proven able to extend and pretend with respect to sovereign credits of varying sizes. Puerto Rico is another case where the threat of a general default is being used to forcibly restructure debt. In the case of GM, which was a sovereign credit for a time, the fact of default was used to ride over investors rights. Indeed, GM may well end up back in bankruptcy because of unresolved pension liabilities and chronic operational problems. CA was saved, for now, by Governor Brown, who is not afraid to say no to both parties in the CA assembly. Which brings us to 60 Minutes and its segment Day of Reckoning. FOLLOW TAYLOR RIGGS ON TWITTER FOR REGULAR UPDATES AND ADDITIONAL >>>

23 Bloomberg Brief Muni Meltdown 23 X: Oh, Meredith Hundreds of billions. With these three words, analyst Meredith Whitney won fame and notoriety and, eventually, ignominy. The payoff: Prominent mention in scores of newspaper, magazine and blog articles, dozens of appearances on business radio and television and of course (in February of 2012) the inevitable book contract. The phrase came almost at the end of a 60 Minutes episode entitled State Budgets: The Day of Reckoning, an otherwise unremarkable and succinct look at public finance by CBS correspondent Steve Kroft, which aired on Dec. 19. Whitney appeared at the end of the segment, in the role of Expert on the Municipal Bond Market. She was, said Kroft, convinced that some cities and counties wouldn t be able to meet their obligations to bondholders. She said there would be a spate of defaults. Asked to define a spate, she replied, 50 sizeable defaults. Fifty to 100 sizeable defaults. This will amount to hundreds of billions of dollars worth of defaults. Patted on the Head Kroft observed that Moody s and Standard & Poor s, who got everything wrong in the housing collapse said there was no cause for concern. Whitney, who, we were reminded by Kroft, had spent (with her staff) two years and thousands of man hours trying to analyze the financial condition of the 15 largest states, wasn t buying it: When individual investors look to people that are supposed to know better, they re patted on the head and told, It s not something you need to worry about. It ll be something to worry about within the next 12 months. Then Kroft said, No one is talking about it now, but the big test will come this spring. That s when $160 billion in federal stimulus money, that has helped state and local governments limp through the great recession, will run out. The states are going to need some more cash and will almost certainly ask for another bailout. Only this time there are no guarantees that Washington will ride to the rescue. Cue the stopwatch. Hundreds of billions was the key takeaway from this segment. Municipalities would default on hundreds of billions of dollars in bonded debt, and within the next 12 months, or at least starting within the next 12 months. Everything else in the segment, you could say, yeah, everyone knows that, everyone knows that, everyone knows that, until you struck the hundreds of billions line, and, well, not everyone knows that. Bold call! The record year for defaults until then was 2008, when $8.5 billion in bonds went into actual or technical default. And Whitney said I went back and listened to the entire broadcast several times, just to make sure I had heard what I thought I d heard hundreds of billions. As in, not $100 billion, but a multiple, meaning, at least $200 billion. And this would be something to be concerned about within the next 12 months. Keep in mind when this 60 Minutes episode aired. It was Sunday, Dec. 19. Most of the market was either already on the end-of-the-year holiday or looking forward to beginning it. Most banks and rating companies probably weren t anticipating putting out municipal market commentaries until January. There are some columns you can t wait to write. This was one of them, for me (see Appendix I). Hundreds of billions seemed to me to be in the realm of the fabulous, and I said so. It made no sense to me that a boatload of municipalities would all choose to renege on their bonds, especially since, as Fitch and others had pointed out just weeks before, debt service usually makes up a small part of their costs. Not paying debt service wouldn t do much to solve their fiscal problems. I also included my own prediction for defaults in 2011: Between 100 and 200, totaling between $5 billion and $10 billion. I wrote the column on Monday (the same day, Whitney appeared on CNBC); it was edited on Tuesday, and was published later that night. It appeared on our Page One on Wednesday. Inexpert Witness By then, both research firm Municipal Market Advisors and Tom Kozlik of Janney Capital had responded to hundreds of billions, MMA saying late Monday, Given the dire certainty presented by Whitney, it is a wonder the US equity markets did not collapse on Monday under the weight of the anticipated demise of the state and local government entities. On Tuesday, Kozlik put out a strategy piece headlined, There is Not a Looming Municipal Market Crisis, Although Many Factors are Stressing Issuers. He advised: Investors should not panic and sell-off municipal holdings. For the next year, and the next, and even well into 2013, when her book, Fate of the States was published, Meredith Whitney was Topic #1 in the municipal market. Never had a personality become such a polarizing obsession. Whitney, whose remarks were really just a punctuation mark on the Muni Meltdown hysteria, after all, came to represent all the inexpert witnesses who had forecast the market s imminent demise. To paraphrase Winston Churchill on the Battle of El Alamein, before Meredith Whitney, the asset class never had a win. After Meredith Whitney, it almost never suffered a defeat. The terms of the debate narrowed. Now instead of a vague meltdown forecast, municipal bond defenders, if that is the right word, could just point to hundreds of billions and say, That s not going to happen, and explain why. I think my column was the most-read on Bloomberg that Wednesday, and I even got a call from our television producers to come on and explain myself. This one column also cast me in a new, heroic role: Municipal market champion. s of thanks and praise came in. This was unfamiliar ground for me. If anything, I was regarded as a scold by many bankers, especially for my general opposition to the use of interest-rate swaps by all but the most sophisticated municipal bond issuers. s ran about four-to-one in my favor, all of which I duly saved. The pro-meredith Whitney ones generally reminded me that Whitney had called Citigroup dropping its dividend and how dare I, a mere journalist, declare myself a better analyst?

24 Bloomberg Brief Muni Meltdown 24 XI: After Hundreds of Billions There were lots of things for the municipal market to focus on in 2011: Bond ratings, new regulations, the future of tax-exemption, bid-rigging, swap termination fees, accounting rules, bankruptcies, defaults. And it did, of course. But the main focus was all-meredith Whitney-allthe-time. Oh, there were a few last gasps of generic big-media hysteria. On Jan. 21, The New York Times led the paper with a story headlined, A Path Is Sought for States To Escape Debt Burdens, about how policy makers are working behind the scenes to come up with a way to allow states to declare bankruptcy. In fact, it seemed that states wanted no part of access to bankruptcy. And in March, Nouriel Roubini presented States of Despair, which, despite the title, was really anti-hysterical. In it, the firm explained all the reasons why a meltdown of apocalyptic proportions, i.e., hundreds of billions, was extremely unlikely, and observed: Our base case sees close to $100 billion of defaults over five years, but typical 80 percent recoveries are far higher than on corporate bonds. Not the Titanic More importantly, Roubini stated that it was incorrect to assume the Titanic is set on autopilot heading for the North Pole. In other words, state and local governments weren t passive observers, and could be expected to try and address the situation. And he called any state bankruptcy discussions dead on arrival. The full title of the Roubini report was States of Despair Part 1: Muni Stress Past, Present and Future. I m not aware of any Part 2 ever being published. But the real story was Meredith Whitney. In February, the New York Times acknowledged as much with a story, A Seer on Banks Raises a Furor on Bonds. Redefining Default For someone who had studied state and local finance for at least a couple of years, she didn t seem familiar with the nomenclature. In 2010, she very briefly tried to redefine default. Rather than meaning missing a debt service payment, or violating a bond covenant, Whitney said that when she used the word default it meant something like breaking the social contract by reductions in spending. Using this definition, everything from curtailing library hours to reducing retiree health-care benefits could be considered a default. You can see how easily hundreds of billions could add up. But of course this was an absurdity. Eventually, in 2011, Whitney said she stuck by her 60 Minutes phrase hundreds of billions of dollars in defaults, but added that it was never a precise estimate over a specific period of time. Yet it sure sounded that way to anyone who watched 60 Minutes. She also used the word restructurings in a corporate way. In the municipal market, when bankers and issuers talk about restructuring, they usually mean refunding a deal so as to extend maturity or at least they did until the Detroit bankruptcy. In the corporate world, restructuring usually means some form of a cramdown. Whitney hinted darkly that there were lots Her words were being misrepresented so that her message might be more easily attacked. Michael Lewis, Author, referring to Meredith Whitney Source: Bloomberg/Simon Dawson Anti-hysterical: Nouriel Roubini of restructurings going on out there in MuniLand, secretly. Whitney also believed the Build America Bond program that was featured as part of the Obama fiscal recovery act represented a kind of hidden bailout to states: These states might have already reached some type of tipping point had the federal program not been in place she wrote in the Wall Street Journal. Such was the critical opposition to Whitney and her hundreds of billions call immediately post- 60 Minutes that journalistic bigfoot Michael Lewis eventually felt called upon to defend her, in his August Vanity Fair magazine piece on California, part of a series he was writing on the financial crisis. Her words were being misrepresented so that her message might be more easily attacked, Lewis wrote. Well, let me stop right there. Whitney did have a larger story to tell, but all most people had to go on was her brief appearance on 60 Minutes with its explosive conclusion. It s not as though the show s non-municipal-market-expert viewers could be presumed to have watched all the various cable news and business radio episodes featuring Whitney. And on the 60 Minutes segment, the most important thing she had said was hundreds of billions in defaults. Whitney s larger message was expounded in Lewis s article, and later in her own continued on next page...

25 Bloomberg Brief Muni Meltdown 25 continued from previous page... book, Fate of the States. Boiled down, it goes something like this: Some states and their municipalities have borrowed too much and promised too much to their employees. This overleveraging will become apparent to all as these governments are forced to cut services and raise taxes. People and companies who can afford to will decamp to greener pastures, those states that haven t borrowed too much and that have low taxes. The new power region of the country is going to be the formerly flyover American heartland, and certain states in the South and West. In April of 2012, at a Grant s Interest Rate Observer conference, Whitney said this would play out over the next two decades. This was indeed a message, a very plausible, reasoned theory, even if I thought it wrong and not a little derivative. Whitney protested to Lewis that she didn t care about the stinkin municipal bond market. And this seemed to be very true, although in November of 2010 she told the Financial Times that she was seeking approval from the SEC to set up a credit rating firm, which would grade municipal bonds, among other things. And on Bloomberg radio s Surveillance, in May of 2012, Whitney said that she only looked at the big picture, not the Cusipby-Cusip (and particular-and-specific) world of munis. Which means that the hundreds of billions call was meaningless, unless somehow also attached to a multi-generational forecast of fundamental demographic shift. The idea that people would vote with their feet and flee the high-cost, high-tax coastal states isn t a new one. I m not sure that this nuanced theory would have garnered the attention, and subsequent book deal, and all the rest of it, that hundreds of billions did. Meredith Whitney didn t respond to my calls and for comment. Stinkin Municipal Market I d like to say that the Muni Meltdown hysteria died of natural causes. The economy revived, tax collections rose, municipal officials did their jobs, defaults didn t explode. That happened. I d also like to say that the hysteria was dispatched by those who knew what they were talking about returning fire with articles and blogpostings and pieces of research dense with unassailable facts and statistics. That also happened. And I d like to say that the willingness of people like David Kotok and Dick Larkin and Alexandra Lebenthal and Matt Fabian, among many others, to appear on business television to explain the municipal market in slow motion I d like to say that quieted the Meltdown hysteria. Because that, too, happened. I suspect the real reason the Meltdown hysteria subsided was because of Whitney. As she told Michael Lewis, she didn t care about the stinkin municipal bond market. Yet that was all the reporters on the Muni Meltdown Hysteria beat cared about, now that there was a specific target: hundreds of billions. Whitney refused to engage. Game over. Briefs on the radio Tune into First Word on Bloomberg Radio at 6:20 a.m. EST weekdays to hear in-depth analysis, commentary and previews of upcoming newsletters from our economists and editors AM New York 1200 AM Boston SiriusXM Brief

26 Bloomberg Brief Muni Meltdown 26 XII: Returning Fire Market participants began returning fire on the meltdown proponents during the second half of Meredith Whitney s 60 Minutes appearance at the end of the year quickened the pace. In the Muni Meltdown Hysteria media game of 2010 and 2011, the burden of proof was always on the market. Meltdown adherents sent screaming headlines hurtling around the web about how the entire municipal market was going to implode, and watch out below. Responsible analysts eager to retain their credibility had to respond with detailed, sometimes ponderous, explanations of why that amorphous and incendiary possibility wasn t the case. Then came Whitney. As I said, it was one thing to respond to the vague meltdown business, quite another to say why hundreds of billions was utterly implausible. Smackdown Some of the best analysis was done immediately after 60 Minutes. The New York Post on Friday, Dec. 24, termed the week post- 60 Minutes a Whitney smackdown (Whitney s husband had been a professional wrestler) and quoted Ben Thompson of Samson Capital, who appeared on CNBC and said the numbers just don t add up. He said, I can t make the numbers work. If you look at the 10 largest cities and the 25 largest counties in the country, that s $114 billion in debt outstanding. So you gotta basically have New York, Chicago, Phoenix, Los Angeles these cities start to default. Source: Bloomberg/Jin Lee Asking simple questions: Citi s George Friedlander For one thing, all of the top municipalities in total do not have hundreds of billions of dollars of debt outstanding. George Friedlander, Citi On Dec. 21, Citigroup s George Friedlander responded at length in the firm s Municipal Market Comment wihout naming Whitney: For one thing, all of the top municipalities in total do not have hundreds of billions of dollars of debt outstanding. Achieving an outcome anywhere close to this projection would require not just that some major local governments would fail in the near future, but that virtually all of them would. If such a result were at all possible, it would be far from a secret, suggestions that municipal market participants rating agencies, municipal finance departments, dealers and portfolio managers are somehow complacent notwithstanding. Friedlander also paused to reflect on the meltdown hysteria: We note that there has been a virtual avalanche of reports of this type over roughly the past fourteen months. The reports had several attributes in common: They were written by individuals whose main expertise was in sectors other than municipal bonds and whose main claim for credibility was that they had been accurate in forercasting disaster in some other sector; They projected that there would be a very sharp upswing in the magnitude of defaults on rated municipal credits in the future, over a relatively short time period (i.e., over the next year or two); and The projections did not appear to treat effectively the differences between corporate credits and state and local credits. Sometimes the simplest questions are the best. How do you even get to hundreds of billions? On Jan. 4, 2011, Michael J. Schroeder, CIO of Wasmer, Schroeder & Co. put out a comment on the subject, showing just how difficult it was, once you netted out the states and bonds that were escrowed with U.S. Treasury securities or their equivalents. 1 in 7 If 200 average issuers defaulted, that might add up to $10 billion, wrote Schroeder. If you took the top 20 cities, they had about $115 billion in direct and overlapping debt, and none of them seemed about to go bust over the next 12 months. Finally: To arrive at a figure of hundreds of billions of par amount defaulting in the next 12 months, by my estimate, over 5,000 issuers would have to default on their municipal debt, or about 1 in 7 that have debt outstanding. At least two more white papers designed to challenge the hysteria appeared. On Jan. 20, the Center on Budget and Policy Priorities published a 21-page white paper entitled, Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm, a nice primer that addressed every aspect of the meltdown hysteria, although it didn t mention Whitney by name. And in February, the Center for Economic and Policy Research published a paper on The Origin and Severity of the Public Pension Crisis, which sought to remind everyone that the real reason so many pension plans were underfunded was because of the shellacking they had taken in the stock market. Any bibliography of bank and rating company responses to the Muni Meltdown Hysteria would probably run to 40 or 50 separate items. Most were distributed privately to clients, but several managed to surface and broaden the debate. That is, to the extent there was any longer any debate. By the middle of the year, it was apparent that Whitney s hundreds of billions and Munigeddon weren t imminent. All that remained was counting defaults and watching the calendar, and pointing out how silly it had all been.

27 Bloomberg Brief Muni Meltdown 27 XIII: What Happened, and Lessons Learned So, the Great Municipal Market Meltdown that didn t happen. Or did it? Jeffco, Detroit, Rhode Island, Puerto Rico. Harrisburg, San Bernardino, Vallejo, Stockton, all before getting to the usual suspects, a colleague ed me. To this I might add, the redefining of the General Obligation bond in the wake of the Detroit Chapter 9 bankruptcy. Point taken. Each of them is exceptional. Each is worth an extended piece on its own merits. First, let s look at what did happen. The recession ended in June of was the year of hysteria, culminating in Meredith Whitney s 60 Minutes prediction. In 2011, 133 issuers defaulted on $6.56 billion in municipal bonds, according to Municipal Market Advisors. This being the municipal market, of course, not everyone agreed at the time about the definition of default. Richard Lehmann, publisher of the Distressed Debt Securities Newsletter, put the 2011 figure at almost $26 billion, if you counted tobacco bonds and the munis backed by American Airlines in the total, and if you counted both actual and technical default. If you counted only actual payment default, the figure was $6.56 billion in 2011, $1.94 billion in 2012 and $8.54 billion in 2013, according to MMA. The total for 2014 will likely top the 2013 total, because of Detroit, says MMA. Now let s consider municipal bankruptcies. Vallejo, California, went bust in May of 2008, pre-hysteria. Central Falls, Rhode Island, filed for Chapter 9 in August of Harrisburg, Pennsylvania, filed in October of 2011, but this was thrown out. The then-record municipal bankruptcy was filed by Jefferson County, Alabama, in November of 2011, the proximate cause failure by the state to allow the county to levy a tax. In the summer of 2012, San Bernardino, Stockton and Mammoth Lakes, California, all declared bankruptcy. Bloomberg News carried a story on July 13: Buffett Says Muni Bankruptcies Set to Climb as Stigma Lifts. In 2012, there were a dozen Chapter 9 filings, most of them for things like sanitation and irrigation districts. Number of Defaults Dropped... Number of Defaults In July of 2013, Detroit became the new record municipal bankrupt. Meredith Whitney penned an opinion piece for the Financial Times, headlined: Detroit Aftershocks Will Be Staggering, or as Business Insider put it in their pickup: Meredith Whitney: Detroit Will Start a Wave of Municipal Bankruptcies. In 2013, there were eight Chapter 9 filings. In the first nine months of this year, there were nine Chapter 9s, none by a city or town or what most people think of 107 $4.03 $6.56 $1.94 Number of Defaults Par Value (in Blns) $8.54 $ Source: Municipal Market Advisors... Investors Withdrew Funds After Meredith Whitney Call In Billions of U.S. Dollars $9.9 Muni Bond Flows $9.4 $21.1 $17.3 $15.8 $81.1 $5.0 -$14.4 $46.0 $ $ Q1-Q3 Source: Lipper US Fund Flows when they hear the word municipality. They included hospital, levee and sanitary improvement districts. In 2009, investors added almost $81.1 billion to municipal bond funds, according to Lipper US Fund Flows. In 2010, they added $5 billion. In 2011, as investors panicked after the Meredith Whitney call, they withdrew $14.4 billion. In 2012, they added $46 billion. Yield indexes shot higher. The oldest gauge of municipal yields, the Bond continued on next page...

28 Bloomberg Brief Muni Meltdown 28 continued from previous page... Buyer s 20-Bond General Obligation Index, rose from 3.82 percent on Oct. 14, 2010 to 5.41 percent on Jan. 20, The index fell throughout 2011 and 2012, rose in 2013, fell in 2014, and is now in the 3s. States and municipalities reduced spending, raised taxes and fees, balanced their budgets and fired employees. States had 5.2 million employees on Jan. 31, 2009, which they cut to just over 5 million by the end of July Local governments had 14.6 million employees in October of 2008; they fired almost 600,000 by March of Both have resumed hiring, albeit slowly. States and municipalities slowed their borrowing in the bond market. In 2010, they sold almost $408 billion in long-term, fixed-rate municipal bonds. This declined to $258 billion in 2011, rose to $352 billion in 2012, dropped to $298.7 billion in 2013, and currently stands at about $220 billion. If I can generalize: If a Municipal Market Meltdown did not and has not occurred, what did happen? States and municipalities, with a few exceptions, muddled along. Federal assistance in varying degrees and interest-rates held near zero by the Fed eased the way. Beware Inexpert Testimony What can we learn from the hysteria? Are there any lessons that investors can learn from the panic of 2010? First: Remember my friend Paul Isaac s dictum: The municipal market is particular and specific to a remarkable degree. Hysteria proponents either ignored, or (my bet) didn t know about the incredible variety of securities and credits sold generically as municipal bonds. They generalized. Second: Beware inexpert testimony offered on the Internet. Not all points of view are legitimate and credible. Third: Politics and municipal credit analysis make strange bedfellows. Many of the dire predictions about the market were politically informed, driven by an almost visceral hatred of municipal labor unions. Consider, for a recent example, a September editorial in the Wall Street Journal about Sen. Chuck Schumer s support for munis as high quality liquid assets for banks. Schumer urged federal regulators to reconsider their decision to prohibit banks from considering munis as such assets, saying it might even slow or halt infrastructure projects. The Journal observed: That infrastructure line sounds nice, but Mr. Schumer s real purpose is to keep the money flowing to his friends in local government so they in turn can keep the money flowing to union employees. I thought: Is this really what the Journal editorial board considers the only pupose of municipal borrowing? Fourth: Municipalities that is, those who are legally allowed to (not all states Source: Bloomberg/Pete Marovich Defending Munis: Sen. Chuck Schumer allow it) will do all they can to avoid filing for Chapter 9, which by design is onerous, extremely expensive and, yes, carries a stigma. The corollary to this observation is that when they do file, the corporate attorneys and advisers involved will target bondholders as easy prey. Even the conservatives in Orange County for a very brief period early in the county s bankruptcy in 1995 talked of repudiating certain bonds sold only the year before. One of Detroit emergency financial manager Kevyn Orr s very first gambits was to declare that general obligation bondholders were unsecured and entitled to only cents on the dollar. Fifth: Twitter is a good source of breaking news and analysis. Dismiss it at your risk. Bloomberg Brief: Muni-Meltdown That Wasn t Newsletter Executive Editor Ted Merz Municipal Market Editor Joe Mysak Newsletter Business Manager Nick Ferris Advertising Adrienne Bills Graphic Designer Lesia Kuziw Newsletter Managing Editor Jennifer Rossa Editor Taylor Riggs Editor James Crombie Reprints & Permissions Lori Husted x2204 To subscribe via the Bloomberg Terminal type BRIEF <GO> or on the web at contact the editors: This newsletter and its contents may not be forwarded or redistributed without the prior consent of Bloomberg. Please contact our reprints and permissions group listed above for more information Bloomberg LP. All rights reserved.

29 Bloomberg Brief Muni Meltdown 29

30 Bloomberg Brief Muni Meltdown 30 Appendix 1: Meredith Whitney Overreaches With Muni Meltdown Call COMMENTARY BY JOE MYSAK Dec. 22, 2010 (Bloomberg) There will be between 50 and 100 significant municipal bond defaults in 2011, totaling hundreds of billions of dollars. So said banking analyst and new municipal bond expert Meredith Whitney on the 60 Minutes show on Sunday, in perhaps the boldest, most overreaching call of her career. Hundreds of billions of dollars? The oneyear 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, as elucidated by 60 Minutes correspondent Steve Kroft. 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. Whitney doesn t believe the states will default. That leaves us with local governments and authorities as the ones failing to pay debt service on their bonds, which makes this an even bolder call. Most defaults in the modern era aren t governmental or what we might call municipal at all. The majority are corporate or nonprofit borrowings in the guise of some municipal conduit nursing homes, housing developments, biofuel refineries so they could qualify for tax-free financing. Whitney s Vision And those are the ones I think will still comprise the majority of defaults in This isn t the Whitney scenario. No, she envisions between 50 and 100 or more counties, cities and towns making the choice to renege on their bonded debt. My question is: Why? Why would a governmental entity go out of its way to provoke or alienate its best source of finance? In the old days you might say that bondholders were a distant class of banks and plutocrats mainly centered in the Northeast. That s no longer true, and hasn t been since at least the passage of the Tax Reform Act of 1986, which made bonds less attractive for banks and insurance companies, among other things. Today, a city s bondholders might live in the municipality itself, and almost certainly reside within the state. Debt Service Why would a governmental entity choose to default on its bonds, especially if they make up a relatively small proportion of its costs? Debt levels for U.S. local and state governments are relatively low, with annual debt service representing a relatively small part of budgets, Fitch Ratings said in a special report in November. Entitled U.S. State and Local Government Bond Credit Quality: More Sparks Than Fire, the report said, The tax-supported debt of an average state is equal to just 3 percent to 4 percent of personal income, and local debt roughly 3 percent to 5 percent of property value. Debt service is generally less than 10 percent of a state or local government s budget, and in many cases much less. The lead analyst on the report was Richard Raphael, who has been covering municipal finance for 31 years. He is not one of the analysts who got everything wrong in the housing collapse, in the words of correspondent Kroft. In his report, Raphael said, debt service is a relatively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action). Headline Grabber What irks me about this Whitney call is that it generalizes about a market that resists generalization, a market that is particular and specific to a remarkable degree. And it doesn t answer the question Why? It is instead an assertion aimed at getting attention. Whitney made headlines in 2007 when she predicted Citigroup would lower its dividend and that it was time to sell bank stocks. She made headlines in September when she said she produced a report on 15 states financial condition, and said the federal government might be called upon to bail them out. Whitney only let clients see the report, so I don t know if her conclusions are supported. She said it was 600 pages long and had taken two years to produce. Perhaps Whitney should stick with bank stocks. Debt levels for U.S. local and state governments are relatively low, with annual debt service representing a relatively small part of budgets. Richard Raphael, Analyst

31 Bloomberg Brief Muni Meltdown 31 Appendix 2: Muni Meltdown That Wasn t Confounds Market s Earliest Critics Dec. 13, 2011 Before Meredith Whitney predicted that municipal defaults in 2011 would total hundreds of billions of dollars in a Dec. 19, 2010 broadcast of CBS Corp. s 60 Minutes, several analysts made similar claims about the imminence of defaults and bankruptcies at the state and local levels. Four people who previously wrote or spoke about the problems facing the market in 2011 discussed their previous statements, why the market held together this year, and what the future holds for state and local issuers with Municipal Market s Brian Chappatta. California Will Default Christopher Whalen: My basic view hasn t changed, and my comment was really more of a medium-term issue. In other words, they re going to try to raise taxes in California, but they re not going to get very far. The whole West is like this. They re antithetical to taxes, especially property taxes. The whole point of the comment was that eventually, the politicians are going to have to use the threat of default to move the political process. And I still think that s the case. Illinois is arguably worse than California now, because they haven t done anything. I was pretty critical of New York last year, but Andrew Cuomo is doing very well. He s well ahead of the other two states. My sense is we still have a risk of at least threatened political default, like we went through with the budget last summer. The question is: What do you do in a flat environment in terms of employment and the real estate market, where there s no automatic appreciation in the tax base? That s the big issue I see. If we re going into a period with flat or down real estate prices, that s not going to help anybody maintain revenues versus rising expenses. So there s a squeeze here between revenues and expenses and I don t think that s going to change. I m not an end-of-the-world guy. What I do think is everyone s premise about revenue and growth has to change, and that s going to ripple through politically, especially in Illinois. I could see them default, simply because the politics are not aligned correctly for people to deal with the issue. The biggest thing I didn t understand when I wrote that paper, which I understand now after I talked to some people who have really been involved in municipal government, is how hard a state will work to avoid any default on a GO bond. Frederick Sheehan, Author In the 80s, when we had the S&L crisis, it took us almost 10 years three congressional elections to change the mix in Congress so they would actually deal with it. And we re going through the same thing now. We may have to not only have an election next year but also an election two years later before you get the mix in Congress changed so they ll actually do this. The old guard politically, they don t want to deal with this. I haven t really changed my outlook, but I m not a doom-and-gloomer. I just think politics, especially in the West, are going Source: Bloomberg/Andrew Harrer Andrew Cuomo to have to get involved at some point, because the population there is still pretty recalcitrant, and they don t think they should have to pay more taxes. They re talking about raising expenditures for the schools. Yet we don t have the money. But they don t want to hear it. Christopher Whalen is managing director of Institutional Risk Analytics, a Torrance, California-based bank-rating firm. He said in an interview with Henry Blodget on Yahoo Finance s Tech Ticker in November 2010 that California will default. Blodget, who is also the chief executive officer and editor-in-chief of Business Insider, later posted on the site the headline: CALIFORNIA WILL DEFAULT ON ITS DEBT, Says Chris Whalen. Let States Go Bankrupt David Skeel: Politically, things have changed since I wrote that piece in terms of the likelihood of it going anywhere in Congress. The political enthusiasm for the state bankruptcy idea has temporarily dimmed. The problems haven t gone away. I still think bankruptcy would significantly improve our ability to deal with a crisis. If the Eurozone crisis were to deteriorate further and have ripple effects here, things could quickly get worse than they are. It has always been quite possible that nobody would get to the edge of default. One of the arguments against bankruptcy for states is the downturn is largely cyclical and they ll almost certainly be able to muddle through. I think that may be right, but it doesn t seem to be a basis for saying we don t need to do anything else. It s like saying there s no need to have a fire department because we haven t had a fire. So the arguments for a state bankruptcy framework remain compelling. One of the criticisms of bankruptcy as a solution is it doesn t solve the political problems. The reason states get into so much trouble is usually because there s some breakdown in the political process. Bankruptcy is not a silver-bullet solution to that. If you ve got political problems, they re probably not going to disappear, but bankruptcy does point in the right direction. Another criticism of bankruptcy is if you continued on next page...

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