Don't Worry Over Largest Ever Muni Bond Default

By Larry Swedroe

(MoneyWatch)

Alabama's most populous county declared bankruptcy in hopes of addressing a massive revenue shortfall and its whopping $4.15 billion in debt. Jefferson County's Chapter 9 filing is the largest municipal bankruptcy in U.S. history.

This formal declaration doesn't necessarily mean investors will lose their money. Consider the 1994 case of Orange County, Calif., which was the largest municipal bankruptcy on record prior to Jefferson County, with debts totaling $1.7 billion. In the end, all debts were fully repaid.

Jefferson County's declaration provides us with a good opportunity to review the overall state of the municipal bond market. Last December, Meredith Whitney caused quite a stir when she predicted on CBS' "60 Minutes" "between 50 and 100 'significant' municipal bond defaults in 2011, totaling 'hundreds of billions' of dollars." Her forecast helped trigger investors to withdraw money from municipal bond funds for 24 consecutive weeks. Unfortunately for Whitney and those investors who gave credence to her forecasts, it would be hard for her to have been more off the mark.

Meredith Whitney on 60 Minutes

The massive scale of problems that Whitney anticipated hasn't appeared because governments have taken actions to address the problem -- cutting spending and raising revenues. Unlike the federal government, states are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services, renegotiation of contracts with union members on wages and especially benefits, and increased taxes and fees. These actions have gotten results. For example:

-- Preliminary data from the Rockefeller Institute reported that state revenues from July and August were 6.8 percent higher than the same period in 2010.

--Standard and Poor's said municipal bond defaults were down 69.0 percent from January through October, versus the same period in 2010.

--Prior to Jefferson county's declaration, outstanding defaulted issues totaled just $6.6 billion.

It's also important to point out that of the now 200 outstanding defaulted issues, 8.0 percent were issued for multifamily residential projects, 10.5 percent for health care, and 43.7 percent for land-backed deals. These are sectors of the municipal bond market I recommend you don't even consider (regardless of the credit rating) because of their relatively poor historical default records.

While the year isn't quite over, the roughly $11 billion in defaults is a long way from hundreds of billions. Keep these results in mind the next time you're tempted to react to some dire forecast. And remember that the academic research on the ability to forecast the future demonstrates that it's not possible. The only good predictor is fame -- the more famous the forecaster, the more likely he or she is to be wrong.

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