U.S. muni market riled by Fed report on defaults

Mon Aug 20, 2012 5:40pm EDT

Aug 20 (Reuters) - The Federal Reserve Bank of New York has riled analysts and other participants in the U.S. municipal bond market with a report issued last week finding that defaults are more prevalent than credit rating agencies suggest.

The report, which included non-rated debt, found that muni defaults "happen much more frequently than most casual observers are aware". For story on report, see

The conclusion is "patently absurd" and may cause people to "question the reliability" of municipal information from the Fed, said Daniel Berger, a senior market strategist at Municipal Market Data, a unit of Thomson Reuters.

In interviews with Reuters, blog posts and web comments on the Fed report, bond buyers, wealth managers, analysts and others pointed to its su pposed s hortcomings.

No one was available at the bank to comment on reactions to the report.

Some market experts were upset that the Fed looked only at the overall number of muni defaults, and not their par value, which would likely be a small portion of the $3.7 trillion muni bond market.

They also say that the report's emphasis on unrated debt -- which is inherently riskier -- is skewed and could lead an unsophisticated observer to believe that the market, which is generally considered one of the safest, is instead dangerous.

"The conclusion of the study is that there are more defaults among non-rated transactions than rated ones. This is a big revelation?" said Chris Mauro, director of municipal bond research at RBC Capital Markets. "Why do you think they were non-rated in the first place?"

In December 2010, Meredith Whitney rocked the muni market by predicting that defaults would surge. That spooked individual investors, who fled the market in the first quarter of 2011.

While investors have since returned to the market, some participants still feel stung.

"Here comes the misleading statistic yet again," Gregory Serbe, president of Lebenthal Municipal Asset Management in New York, told Reuters in response to the Fed's report.

"We've had to, over the last few years, react to very outsized reports of potential defaults that were coming down the road," Serbe said. "That's unfortunate, because the bulk of municipal bonds are going to pay their interest and principal in a prompt and timely fashion."

MARKET TRIES TO UNDERSTAND SCOPE OF TROUBLE

Even so, some issuers are in serious trouble -- including a trio of California municipalities that filed for Chapter 9 bankruptcy since June. On Friday, Moody's Investors Service said it is considering credit rating downgrades in the state as bankruptcies there will likely increase.

The bad news has put the marketplace on edge as it struggles to understand the true scope of the problem and predict which issuers could possibly go under. Nobody knows the answer for sure.

In the Fed's report, researchers found that from 1970 to 2011 there were 2,521 defaults on bonds -- both rated and unrated -- from about 55,000 issuers.

That number is far larger than the 71 defaults listed by Moody's Investors Service over the same period of time, and just 47 listed by Standard & Poor's Ratings Services since 1986.

For corporate bonds, a market with an outstanding volume double that of muni bonds by dollar value, but with just 5,700 issuers, Moody's reported 1,784 defaults and S&P reported 2,015, the Fed study shows.

The Fed's report "painted an incomplete picture and perhaps unwittingly gave the a platform for biased reporting," said Stephen Winterstein, head municipal strategist at Wilmington Trust.

He and others point out that while 2,521 defaults may seem like a significant increase over the dozens reported by the rating agencies, those defaults likely represent a small share of the market when measured by the par value of the bonds at stake -- in part because they're generally much smaller bond issues.

For example, Moody's rates an estimated 22,000 issuers, but $3.36 trillion, or about 91 percent, of the market based on par value. S&P likewise rates about 22,923 issuers, but $3.17 trillion, or 86 percent, of the market by dollar value, according to Winterstein.

If the dollar value information were included, "the default reports published by the rating agencies give us a different and perhaps more comprehensive view of credit stress in the municipal market," Winterstein said.

Some did find the report useful. One credit analyst said in the report's comment section that it is "important to realize the different default rates for the different sectors of the muni market."

The bank also spelled out the difference between safer, general obligation bonds and often riskier revenue bonds. And it noted that issuers who believe their bonds won't earn investment-grade credit ratings are less likely to seek out ratings in the first place.

Of the various kinds of markets, the world of municipal bonds can seem fragmented, and its participants often assert that it defies broad descriptions. Its 55,000 issuers cover 22 sectors, 50 states and 5 territories, with stratified credit structures, experts said.

"Any sweeping generalization should be looked on with a suspicious eye," Winterstein said.

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