Meredith Whitney, Valentine Pundit, Wrong On Munis

On Thursday, February 7, as I do most days, I watched Bloomberg Television’s Surveillance from an exercise bike while sipping my morning coffee. Sara Eisen, Scarlet Fu, Tom Keene, and Mike McKee were interviewing Meredith Whitney.

First disclosure: Meredith Whitney and I have had our disagreements over municipal bonds and municipal bond strategies. This was exacerbated by her infamous call on 60 Minutes, in December, 2010.

In the recent Bloomberg interview, Meredith sponsors the notion that the banking sector is improving and that the results will reflect in bank stocks. The case she makes for the sector is bullish.

We completely agree with her on this issue. We think her recommendations and her arguments are sound. In the banking sector, she is our Valentine pundit.

Second disclosure: Cumberland has been overweight the banking sector and financials since this bull market started. We use only ETFs. The ones we own represent regional banks, big banks, insurance companies, and small specialty types of financial institutions. Those ETFs as a group are overweight banking relative to the benchmark index. We are fully invested, according to our internal asset-allocation weighting models. We believe these assets will attain much higher prices over time.

Meredith Whitney established herself in the banking sector with a famous call about Citigroup. We agreed with her call then, and we agree with her banking sector call now. While our job is not to make calls but to manage portfolios, we believe it is correct to praise where praise is due. In the banking sector, Meredith has and does earn that praise.

One of the big issues that prompted our public disagreement with Whitney involved her call on municipal bonds. In that call she articulated a prediction that “hundreds of billions of dollars worth of defaults” would occur. Furthermore, she expected that it would happen in 2012. We disagreed.

Our view on Munis has several components. First, some municipal bonds default every year. Most of them are in the junk-credit category or are tied to specific projects.

Second, we see no way that annual defaults could reach Meredith’s massive numbers. This is especially true with the ongoing quantitative easing by the Federal Reserve. Furthermore, municipal finance is slowly improving in credit quality in many jurisdictions due to the ongoing economic recovery. That recovery, underway since 2009, is proceeding at a slow but gradually increasing pace.

Third, Meredith ignored the idiosyncratic nature of tax-exempt municipal securities. There are approximately ninety thousand issuers in the US, which fall under the governance of nearly that many state and local jurisdictions; and the claims upon them are equally various. You cannot paint the tax-free or taxable municipal bond sectors with a single broad brush. That just does not work. It did not work with her 60 Minutes prognostication, and it did not work for those investors who thought that they could buy insured bonds and that those bonds were all gilt-edged. That is and was a fundamental flaw in certain bond funds.

In order to successfully invest, own, or lend your money to a municipality, or to otherwise place capital in the municipal bond sector, you must carefully research the credit and structure of the specific instrument. There is a vast difference between the nature of a general-obligation pledge versus a budget funded by an annual appropriation in a city in California. There are very strongly monopolistic government franchises, such as the NJ Turnpike. Essential-service revenue bonds are available with tight liens and claims to secure the bond holders. Many Munis are quite solid when it comes to credit.

In the February 7th Bloomberg interview, Meredith Whitney was asked specifically about her history with the municipal bond call. Readers can judge her response for themselves. See her interview on Bloomberg.

Her famous “100 billion dollar default” interview is here.

Our view is that one must do the analysis on credit. There are many opportunities in the municipal bond sector. Default on them is unlikely and default in a massive scale is also unlikely.

To Meredith and to all readers, we wish you a happy Valentine’s Day.

BY David R. Kotok