Whitney's Muni Forecast Is Short on Specifics

"There's not a doubt in my mind that you will see a spate of municipal-bond defaults," the banking analyst Meredith Whitney, nodding her head, said on a Dec. 19 segment of CBS's 60 Minutes.

"How many is a spate?" correspondent Steve Kroft asked.

"You could see 50 sizable defaults, 50 to 100 sizable defaults, more," said Whitney, 41, who made her name covering bank stocks. "This will amount to hundreds of billions of dollars' worth of defaults."

Those two sentences set off a month of fireworks in the almost $3 trillion muni market. California Treasurer Bill Lockyer called the prediction "apocalyptic arm-waving." The National League of Cities' research director cited her "stunning lack of understanding." Pimco's William H. Gross, who runs the world's biggest bond fund, simply said he doesn't subscribe to the "theory."

James A. Bianco, the president of Bianco Research in Chicago, compares the attacks on Whitney with the fury directed at New York University economist Nouriel Roubini, who in 2006 predicted the financial crisis. "Everybody was lining up to tell us why Roubini was wrong, and he wasn't," Bianco says.

Meanwhile, investors pulled about $4 billion from municipal-bond mutual funds in the week ended Jan. 19, the most since Lipper U.S. Fund Flows started compiling the data in 1992. Investors have withdrawn money from muni funds for 11 straight weeks, as of Jan. 26, according to Lipper, taking out $22.5 billion. Returns on municipal securities fell the most in 16 years in the fourth quarter of 2010, according to the Merrill Lynch Municipal Master Index. The cost for AAA-rated issuers to borrow for 30 years climbed by almost a third, to 5.09 percent on Jan. 17, from 3.85 percent on Nov. 1.

"We've got terrified clients who call constantly and want reassurance because Meredith said there's going to be hundreds of billions of dollars of defaults," says David R. Kotok, chief investment officer at Cumberland Advisors in Vineland, N.J., which manages more than $1.5 billion.

While Whitney is not retreating from her prediction, she says she doesn't have specific numbers to back it up. "Quantifying is a guesstimate at this point," she told Bloomberg on Jan. 30. "I was giving an approximation of a magnitude that will bear out to be correct."

Whitney, a Brown graduate who worked at Oppenheimer & Co. (OPY) before setting out on her own, is not the first to warn of trouble in the muni market. Richard Ravitch, then New York's lieutenant governor, cautioned about "cracks in the municipal-bond market" in 2009. Yet Whitney, who was a contributor on Fox News Network (NWS) from 2003 to 2007, has become a media luminary, and her views generate a lot of attention.

On Sept. 28, Meredith Whitney Advisory Group, the New York firm she started after correctly predicting Citigroup's 2008 dividend cut, produced a report for clients called "Tragedy of the Commons." The report does not say anything about sizable defaults amounting to hundreds of billions of dollars. Nor does a long addendum that profiles 15 states, according to a person who has seen it. Asked why not, Whitney says: "There are fifth-derivative dimensions that I don't think I need to spell out to my clients."

On page 2, the report says, "While we do not believe defaults on debt at the state level pose a significant risk, we believe there will invariably be defaults at the local level," and does not elaborate. Whitney's thesis is that struggling states will cut aid to local governments. The report adds that "states will default in a different way. We believe states have and will continue to default on social contracts in the form of reduced spending" on programs, including education and transportation.

On Nov. 16, in a video interview with the Financial Times, she said defaults would spark "panic in the muni markets." In a Dec. 21 appearance on CNBC (GE), she said states and cities would have to make severe spending cuts and used the phrase "social unrest" twice. Whitney says she doesn't remember using the word "panic" and that the phrase "social unrest" now "seems very loaded" because of the events in Egypt.

"She's trying to shock the market into a panic mode," says Thomas G. Doe, chief executive officer of Municipal Market Advisors, a research company in Concord, Mass. "All she has done is reiterate her headline, but there's no substance."

Whitney's comments aren't the only factor behind muni price declines, says George Friedlander, Citigroup's (C) municipal strategist. In November, when the Federal Reserve started buying U.S. government debt under its quantitative easing policy, the yields on Treasury securities rose, making them more attractive relative to muni bonds. In addition, the market was flooded by states and cities rushing to sell federally subsidized bonds under the Build America program before a yearend deadline, depressing prices.

On Nov. 16, a Fitch Ratings report said that even if there are more defaults than in recent years, they will "continue to be isolated situations." It notes that states and cities can raise taxes and adds that "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)."

Municipalities rarely fail to make their principal and interest payments to investors, according to Moody's Investors Service, which counted 54 bond defaults over a 39-year period in a report last year on securities it rates. There were $2.7 billion of municipal defaults last year, according to Richard Lehmann, the Miami Lakes (Fla.) publisher of Distressed Debt Securities Newsletter. That was down from a record $8.5 billion in 2008. Lehmann's numbers include securities that were issued without ratings.

Whitney's warnings come as she is trying to build a bond-rating business. On Nov. 10, Whitney met with U.S. Securities and Exchange Commission Chairman Mary L. Schapiro to discuss her company's planned application to be approved as a "nationally recognized statistical rating organization" that would compete with Standard & Poor's (MHP), Moody's (MCO), and the eight other accredited companies. Whitney says she expects to hire "hundreds of people" to cover municipal securities. She would also rate corporate debt and structured products.

Asked how her rating service would distinguish itself from rivals, she says she has "an untarnished track record." Bloomberg News reported in October that about two-thirds of her stock picks since starting her company in 2009 had fared worse than market indexes. Visa (V) fell 14 percent after she called it her "single best buy," and Capital One Financial (COF) tripled after she urged clients to sell. "Those are not fundamental calls," she says. What really matters are her analyses of major trends in the industry, she says. "You want to play, let's play," Whitney says, handing over a stack of reports dated from 2001 to 2009, on topics from Goldman Sachs (GS) to consumer spending.

The criticism of her default predictions "doesn't feel good," she says. "What are you going to do?" Whitney says she believes her views put her in "great company," mentioning former President Bill Clinton, who told CNBC on Jan. 27 that he suspects that in the next 60 to 90 days people across America will be trying to figure out ways to restructure local debt. A day earlier, billionaire investor George Soros told the network that state and local finance will provide "the drama of the next year or so."

Whitney does not expect to wait long to be proved right. "I don't think July's going to roll around without defaults," she says. And if she's wrong? She says she'll "adjust."

The bottom line: While she still sees widespread muni bond defaults, Whitney won't offer specific numbers backing her 60 Minutes predictions.

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