So whatever happened to that Armageddon in the $475-billion municipal bond fund market?

Late last year, Meredith Whitney, a banking analyst and principal at the research firm Meredith Whitney Advisory Group LLC who gained a reputation for market savvy with her sage 2007 warning that Citigroup would need a massive capital infusion, shocked investors when she went on "60 Minutes" and predicted that somewhere between 50 and 100 struggling municipalities were headed for default and that investors would lose “hundreds of billions of dollars.”

Her dire words led nervous bond investors, who had been pouring money into munis throughout 2009 and the first three quarters of 2010, to pull $48.5 billion out of municipal bonds and bond funds over the next 29 weeks until a turnaround in early June, according to the research firm Lipper. An additional $500 million was withdrawn from muni ETFs over that period, Lipper reported.

In reality, there was no wave of defaults in the muni bond market. In fact, there were only 26 defaults in the first six months of this year accounting for a total default volume of $818.2 million. That is sharply down from 60 defaults, worth $2.8 billion, over the same six-month period last year.

Hardly Armageddon.

To be sure, municipalities and many states are struggling with reduced revenues because of the struggling economy, as well as the loss of federal funds as the last of the 2009 federal stimulus funds have dried up, with no more federal aid in the pipeline. 

Where Whitney may have gotten it wrong was in assuming that strapped budgets and shriveled tax bases would lead local or even state governments to skip interest payments on their debt rather than cut services to their residents or lay off workers.

In fact, as Richard Lehmann, president of ISA, a Florida-based investment advisory and research firm, told Reuters, "Default is only going to happen when the municipality runs out of cash. If you don't pay your bonds, then you lose the conduit for maintaining your liquidity. So it's one of the last things you're going to cut."  

As it happens, issuers of municipal bonds have been slashing workforces (39,000 jobs cut in June alone by public agencies, state and local, according to Friday's report from the U.S. Bureau of Labor Statistics)  and cutting services, but they have been making their debt payments on time.  

Whitney, who was traveling and unavailable for comment Friday, as recently as May had been sticking to her guns.  On her firm's website, she said that municipalities and states are still “enormously overleveraged” and are limited in their responses because they are required to have balanced budgets.

It’s either cut services, which she said are being cut to the bone, or de-leverage.

Her conclusion: “Municipal bond holders will experience their own form of contract renegotiation in the form of debt restructurings at the local level. These are just the facts. The sooner we accept them, the sooner we can get state finances back on track, and a real U.S. economic recovery underway.”




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