In the wake of the trifecta of California municipal bankruptcies, we couldn't help but remember Meredith Whitney's December 19th, 2010 prediction that "between fifty and a hundred counties, cities, and towns in the United States would have "significant" municipal bond defaults starting in 2011, totaling "hundreds of billions" of dollars in losses." Whitney had received much fame for her accurate and bearish prediction on Citigroup (C) back in 2007 when she was with Oppenheimer and Company and she had made this prediction when she appeared on CBS's 60 Minutes.
Since the largest annual amount of municipal bond defaults was $8.2B in defaults for 2008 at the peak of the crisis, many individuals and professionals felt that she was exceedingly bearish on the municipal sector and needlessly trying to top her call on Citigroup. We decided to use the performance of the iShares S&P National AMT-Free Bond Fund (MUB) as a proxy for municipal bond performance since Whitney's prediction because it is the largest municipal exchange traded fund. Since Whitney's prediction of doom for municipal bonds, the MUB has generated a total return of 16.5%, which exceeded the SPDR High Yield (JNK) and the iShares BarCap U.S. Aggregate Bond ETF (AGG). We expected it to underperform the iShares TIPS (TIP) but surprised to see it underperform the iShares California Municipal ETF though.
Source: Morningstar Direct
Stockton, CA was the first of the three California municipalities that filed for bankruptcy in the last 30 days. Its bankruptcy gave it the dubious distinction of being the most populated American city to ever file a Chapter 9 bankruptcy. We are not surprised that Stockton would be in financial distress, since it was rated as the most miserable city in the US by Forbes. Despite the fact that Stockton's fiscal year ends on June 30th, it has not released a CAFR report for the 2011 fiscal year. Stockton saw its budget go from a surplus of $93M in FY 2007 to a deficit of $50M in FY 2010 and we expect that the city's deficit has widened for the 2011 and the 2012 fiscal years. The rapid shift from surplus to deficit in this three year period was due to a $50M revenue decline and reductions in state aid, as well a 31% increase on public safety spending. We noted that the city has $1.1B in net assets as of FY 2010. Unfortunately, the city has $842M in bonded debt as of FY 2010 versus $408.5M in liquid assets and we expect that to be more unfavorable as of FY 2012. Stockton also has a crime rate that is more than double the national average. The rapid shift in its demographics may have contributed to this. That probably explains why Stockton spends more than half of its revenue on public safety and administration, versus 44% for fellow bankruptcy city San Bernardino and 36% for Boston, MA, which is our hometown.
Mammoth Lakes was the next of the three California municipalities to file for bankruptcy in the last 30 days. We were surprised to see this city filing for bankruptcy since we had remembered it as a quaint tourist town with beautiful scenery. Mammoth Lakes is a small tourist town up in the Sierra Nevada mountain range. The area provides visitors and residents ample opportunities for skiing, hiking and other outdoor life activities. Transient Occupancy Taxes account for more than have of its revenue inflows. The town had incurred a budget deficit in five out of the last seven years. Despite this, we believe that this deficit spending was manageable; given that the town has averaged over $120M in net assets during this time period and that its 2011 cash balance of $12M exceeded its liabilities (excluding lawsuit judgment) of $6.6M.
Unfortunately for Mammoth Lakes, the town lost a $30M judgment on a breach of contract lawsuit with a developer ($43M with interest and penalties). The lawsuit related to the 1997 deal between the town and developer Terrence Ballas to expand and modernize the airport and build a hotel, gas station, restaurant, condominiums and a recreational vehicle park. After the deal was stalled by an environmental lawsuit, the town backed out in 2004 when the Federal Aviation Administration, which was financing airport improvements, said the development plan was incompatible, said Charles Long, who was the interim town manager at the time. If only Mammoth Lakes had the foresight and forward thinking to include force majeure or other similar provisions in the contract in order to enable the town to walk away from the deal because of events like the environmental lawsuit and the FAA rejection.
Source: Mammoth Lakes 2011 Single Audit Financial Report
San Bernardino was the third California municipality to file for bankruptcy in the last 30 days and was the second largest city to file bankruptcy, right after Stockton. Despite the fact that San Bernardino's fiscal year ends on June 30th, it has not released a CAFR report for the 2011 fiscal year. Considering that the city went from a $31.6M budget surplus in FY 2007 to a $23.1M budget deficit in FY 2010, we expect that the city's deficit has widened for the 2011 and the 2012 fiscal years. The rapid shift from surplus to deficit in this three year period was due to a $15M revenue decline and a $39.7M increase in spending. If the city had merely held the line on spending rather than increasing it by 14.6% during this period, it would still enjoy a surplus. We noted that the city has $638M in net assets as of FY 2010. Even if the city experienced the nearly $100M in deficits we predicted, it would still have ~$540M in net assets. Unfortunately, the city has $370M in bonded debt as of FY 2010 versus $174.5M in liquid assets and we expect that to be more unfavorable as of FY 2012. We have been surprised to see that like Stockton, San Bernardino has seen such a rapid shift in its population base from middle class whites to low-income Mexicans in the last forty plus years. Unlike Stockton and the San Joaquin Valley, San Bernardino and the Inland Empire were more residential and suburban. Like Stockton, San Bernardino also has an above average crime rate.
(click to enlarge)
Source: San Bernardino 2007-2010 CAFR Reports and Saibus Research Forecasts
In conclusion, we believe that it is too early to say whether Meredith Whitney's municipal massacre prediction was accurate or not. If things keep on the same trend that has occurred since her prediction, we believe that her prediction will end up being a tempest in a teapot. In our opinion, we believe that Meredith Whitney's prediction could have benefited from additional detailed information and in our upcoming follow-up on Meredith Whitney and Municipal bankruptcies, we will elaborate further on why we believe so. We have noted that Whitney herself had provided additional remarks on the municipal bond situation in a Vanity Fair article with Michael Lewis; however we believe that our follow up report will provide investors a more informative analysis on the muni markets. Maybe she and her firm provided additional research, analysis and evaluation on her municipal bond market prediction exclusively for her firm's clients? We know that if we were on a widely watched and recognized television program like 60 Minutes, we would probably provide greater detail on our prediction than what you would get on a television program segment and we'd probably at least provide an executive summary of our analysis so that everyone can see what we are talking about.
Disclosure: I am long C.
Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.
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