Chicken Little

Author: David Kotok, Post Date: January 16, 2011

We do not want to diminish the important debate about fiscal policy and budget austerity. It is global and it is critical. This commentary is about distinguishing between facts and unsupported, shrill, distracting assertions.

First, the US federal fiscal mess.

The link to the full story (subscription required) is The numbers are real. The political hyperbole is not.

If the US does not get its finances in order “we will have a European situation on our hands, and possibly worse,” claimed Paul Ryan, the new Republican chairman of the House of Representatives budget committee. The consequences of not tackling the country’s mounting debt burden would be dire, he told an audience of leading budget experts and economists at a gathering in Washington last week. “We will have the riots in the streets, we will have the defaults, we will have all of those ugliness problems,” he said, referring to “French kids lobbing Molotov cocktails at cars, burning down schools because the retirement age will be moved from 60 to 62.” Source:

Really? Molotov cocktails in the US? Maybe that is enough of a threat to cause Congressman Ryan to push for repeal of billions in ethanol subsidies. They trigger high food prices and cause food riots in parts of the world. Ryan seems shrill to me. But it is political rhetoric and it is offered at the start of the budget negotiation and in the face of a debt-limit debate in the Congress. Anything less shrill would be a pleasant political surprise.

Now to Muniland.

Meredith Whitney continues to forecast large ”defaults” in the Muni sector. She is now saying that none of the 50 states will default but that 50 to 100 cities and $100s of billions of Munis will default. Chicken Little? Or Cassandra? Time will tell.

In Muniland, mutual fund redemptions are driving fund managers to liquidate tax-free Muni bond positions into a market with falling prices. Pricing references for bonds are used to reprice the estimated market value of all bonds. Very few Munis trade every day. The Muni sector is not like the stock market; pricing is not transparent. So unsophisticated investors watch their prices seem to fall and they hear the media hype and they panic. That triggers more mutual fund redemptions and the cycle repeats itself.

Right now, there are Munis backed by federally guaranteed payment streams that are trading at yields above their US Treasury counterparts. The Munis are tax-free. The treasuries referenced are taxable. Clearly, this is not about credit risk or default risk. We are talking about bonds that have the US government as the source of credit on both sides of the comparisons. Clearly, something else is going on.

Market anomalies happen and can be explained. This one is no different. On the sell side, you find a forced seller in the mutual fund. The manager of the fund has no choice because he must raise the cash to pay the redemption on the day it occurs. On the buy side, the retail investor is terrified and sits on the sidelines. So there is a huge imbalance between buy side and sell side.

Meanwhile, media hype about massive defaults inflicts psychological damage on the investors who might otherwise want to buy tax-free bonds. So they are frozen like a deer in the headlights.

At Cumberland, we find this period to be one of the great bond buying opportunities of a generation. We are able to “cherry pick” the tax-free Muni landscape. Unlike the Chicken Little forecasts that paint a market of 90,000 separate items as if it is homogeneous, at Cumberland we examine each credit and screen out the Harrisburg and Vallejo trash. We did not buy them and would not own them.

But we would buy and do own tax-free Muni credits like the NJ Turnpike, San Diego airport, Nebraska housing, and Chicago Met Pier.

So Meredith, we challenge you. We have named names of Munis we hold for clients and where we believe there will be no default. Let us hear the names of those that you say will default. Surely, you can offer examples to back up your assertions about “50 to 100 cities.” Let us compare facts and CUSIP numbers and bond indentures instead of innuendo and assertions and hype.

We return from the GIC meeting in Santiago on Monday night and expect to be in the office by Tuesday afternoon.

David R. Kotok
Chairman and Chief Investment Officer
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