Municipal Bonds and Fareed Zakaria

Two things I want to talk about in this blog - about a recent meltdown of municipal bonds prediction by Meredith Whitney (http://seekingalpha.com/article/243169-why-you-should-listen-to-meredith-whitney-s-municipal-bond-default-thesis?source=yahoo) and Fareed's TV interview with a bunch of CEOs on christmas day.

Meredith Whitney predicts a wave of municipal bond defaults that is about to hit the US municipal bonds. She thinks it will probably in the order of $100 to $150 billion. Again she argues based on the sagging revenue base of municipalities and their big pension obligations. But she doesn't take us thru a picture how exactly the municipalities would default. The recent experience of Vallejo,CA and Harrisburg, PA have provided a picture of how difficult, costly and messy it is to default. It is not like a homeowner defaulting on his/her home payments and the creditor can come in to foreclose and auction the property to the higher bidder. and also it is not a like a company that can be either taken over by a new management (after shedding liabilities in a bankruptcy court) or completely folded down in a organized sale of assets. A municipality is a local government entity that is there to provide services to its residents and it can't be liquidated. It is a non-profit entity. The reason they issue bonds is that they have to raise money to undertake big capital projects (like school buildings, sewer, water treatment etc) and they can pay the bondholders over a period of say 10 or 20 years thru assessing property taxes and local sales taxes. The municipalities are in a tough situation right now because their revenues are not enough to pay the annual bond payments plus the other obligations of the municipality (like salaries, pension payments, healthcare premiums, services maintenance etc. ). The economic slow down has affected their revenue base. Defaulting or renegotiating the bond payments is not easy. They have to go thru a court process to do this and it takes money to pay lawyers. The other big issue is that if a municipality does do the default, it will have a hard time raising money next time at good rates. Defaulting doesn't solve any problems for a municipality and it is much better for them to raise taxes or get support from the State govt. Which is why I believe that this wave of municipal defaults will not happen and I am slowly investing in municipal bonds (have a position in AKP that now pays 7.2% tax free yield). The bonds may go down because of default fear and I see it as a good investing opportunity to pick up some yields for the portfolio.

The other issue I want to talk about is the interview of Fareed Zakaria with some CEOs on christmas day on CNN. At the end of the interview, Fareed gave his view on why the US is stuck in this slowdown and high unemployment. His take was that our economy is powered by 70% consumer consumption and we are not investing much in the economy. We need to invest a lot more in R&D and other infrastructure. GDP of an economy powered by 70% consumption is not in and of itself a bad thing. This happens in mature economies where the need to build roads, electric grids is not that great as in developing economies. When consumer consumption is only say 40% of the economic activity, the other 60% is coming from infrastructure investments and net exports. Infrastructure investments like road building is an economic exchange between businesses and the govt and so is not part of end consumer consumption. and yes, the exports driven economy require less internal consumer consumption but as I have said before, all countries in the world cannot run a net export surplus. For long-run growth, we have to improve the skills of our people and that requires a cultural change among the population to see the importance of a high school and graduate education. It is not just building more schools and more universities - the population has to be coaxed to believe that education is a must for living. It is more the soft campaign and marketing stuff. A 70% consumption driven economy is not the problem that is dogging our economy - it is the lack of skills among the population compared to the world that is dogging it. Globalization has allowed Companies to shop around the world for the skills and that has made life a lot more difficult - the competition is not regional but global now.

Should the Fed buy more bonds or not

There were two interesting articles on Barrons this weekend - one arguing for why the Fed should shop till it drops and the other on Lessons of History about hyperinflation due to excessive borrowing. John Hatzius of Goldman Sachs argues that a relatively large percentage gain in the growth of the economy (or GDP) is required to induce a decline in the unemployment rate (Okun's Law). Quantitative easing can release the animal spirits to get the economy going again (even if it is a blunt instrument right now). For him, deflation is a much bigger threat than inflation. On the other side, Victor Sperandeo asks if a nation financing 50% of its budget expenditures in the debt market grow itself out of a collapse? He has some good data. US govt debt is now over $13.7 trillion (not including state's debt of $2.8 trillion and agencies debt of $3.0 trillion). The average rollover period for the debt is 49 months. With recent deficits running over $1 trillion a year, the Treasury issues new debt and refunds old debt at a rate of about $4.3 trillion a year. He thinks investors in US debt will begin something similar to a run on the bank, selling Treasuries, even at severe losses. The break point occurs when a government borrows an amount equal to 40% of its expenditures over an extended period of time. and when this happens, it triggers a hyperinflationary spiral. He uses the example of Zimbabwe currently and France in 1790s as an example. The US still owes most of its debt to its own citizens.

Both these guys just use numbers to justify their stance without looking at the productive capacity of the US economy. Why did Zimbabwe get into hyperinflationary situation - nobody wanted to trade with them anymore and they had killed their agricultural economy due to the land seizure program. The agricultural products and mining products was what Zimbabwe used to trade with the outside world to get other things that they couldn't make internally. Hyperinflation is more a result of losing productivity rather than just printing more money. As I have mentioned in my previous blogs, china is buying US Treasuries not to earn a good return but they have no other avenue to put the dollars to work. Yes, they can buy assets around the world but buying assets in other countries (including the US) is not easy and buying a physical asset requires active management. China could stop trading with us to reduce the flow of dollars to it and it would be more bad to China than the US. Feds buying US Treasuries is not going to trigger inflation unless the banks lend the money and the consumers trigger a demand greater than the installed capacity. The unions at manufacturing companies have a lot less leverage these days to demand big pay raises.

What are the avenues an investor has in putting saved money to work - buy into the stock market or the bond market around the world. If the economy is not growing, then the stock market is not going to give a decent return. Then the main avenue to put the money to work for a greater than zero return is to invest in govt securities and the US Treasuries still offer more protection than other govt securities around the world. If the economy did grow, then the deficit issue of the US govt will get solved and so does the unemployment issue.