CBS 60 Minutes: “Day of Reckoning Is at Hand!”

At this very moment, cities and states all across this country are facing their day of reckoning, with far-reaching consequences for the economy, investors and every American citizen.

This morning, I will show why this day is so urgent, how to protect yourself and even how to profit from the crisis. But first …

Some Dire Warnings from the Past

J. Irving Weiss, Abraham Weiss, and Rubin Weiss, circa 1929.

Back in the 1930s, when my father and his brothers were beginning their career on Wall Street, the finances of thousands of cities and dozens of states were in shambles.

More than $5.5 billion or 30% of their bonds defaulted.

Nearly all slashed or even shut down schools, libraries — even police and fire stations.

Dad’s colleagues on Wall Street had said it could never happen. But it did.

Four decades later, when I was in Brazil in 1970, I saw a similar phenomenon.

City budgets were gutted.

Public buildings were sold off to the highest bidder.

Public employees and other creditors waiting for up to six months to get paid.

Today those same cities in Brazil are in much better shape. But, unfortunately, we cannot say the same for our cities and states in the United States.

Indeed, more recently, when I predicted that rich states like California and New York — plus thousands of cities of all sizes around the country — would suffer a similar crisis …

Moody’s, S&P and Fitch
Scoffed and Growled

Moody’s, S&P and Fitch are paid huge fees by thousands of state and local governments for giving them ratings that are typically overinflated.

They’re paid additional fees for rating the insurance companies that supposedly guarantee the municipal bond payments for investors.

And then they rake in all those fees year after year simply by maintaining ratings that are often based on grossly outdated data.

Now, that municipal bond ratings farce — based on payola and riddled with conflicts of interest — is collapsing for three reasons:

First, it’s collapsing because the entire concept of municipal bond insurance — riddled with the same conflicts — has crumbled, just as I warned in The Ultimate Safe Money Guide.

Two of the largest bond insurers — Ambac and FGIC — are already bankrupt, with FGIC now subject to possible liquidation by New York State regulators.

And MBIA Inc., the only surviving bond insurer among the Big Three, has just been downgraded by three notches to B- — deep into junk territory.

Result: Hundreds of thousands of investors who bought insured bonds are now vulnerable. They thought they were buying protection against default. Instead they got little more than a pig in the poke.

Second, it’s collapsing because many cities are years behind in providing accurate financial data … while their finances have deteriorated in a matter of months.

Consequently, a large portion of the data is not only grossly outdated … it’s downright wrong, failing to properly reflect the recent sharp deterioration in local finances.

Third, the muni bond ratings farce is collapsing because of the disastrous situation on the ground. Consider these excerpts from 60 Minutes:

In the two years since the “great recession” wrecked their economies and shriveled their income, the states have collectively spent nearly a half a trillion dollars more than they collected in taxes. There is also a trillion-dollar hole in their public pension funds.

The states have been getting by on billions of dollars in federal stimulus funds, but the day of reckoning is at hand. The debt crisis is already making Wall Street nervous, and some believe that it could derail the recovery, cost a million public employees their jobs and require another big bailout package that no one in Washington wants to talk about.

“The most alarming thing about the state issue is the level of complacency,” Meredith Whitney, one of the most respected financial analysts on Wall Street and one of the most influential women in American business, told correspondent Steve Kroft. …

“It has tentacles as wide as anything I’ve seen. I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S. economy.”

Next, 60 Minutes provides a rundown of the woes of states. It’s shocking. But it barely scratches the surface:

California, which faces a $19 billion budget deficit next year, has a credit rating approaching junk status. It now spends more money on public employee pensions than it does on the state university system, which had to increase its tuition by 32 percent.

Arizona is so desperate it sold off the state capitol, Supreme Court building and legislative chambers to a group of investors and now leases the buildings from their new owner. The state also eliminated Medicaid funding for most organ transplants.

Then there’s New Jersey. It has the highest taxes in the country, a $10 billion deficit and a depressed economy when first-year Governor Chris Christie took office. But after looking at the books, he decided to walk away from a long-planned and much-needed project with New York and the federal government to build a rail tunnel into Manhattan. It would have helped the economy and given employment to 6,000 construction workers.

Gov. Christie acknowledged that’s a lot of jobs. … “The bottom line is I don’t have the money. And you know what? I can’t pay people for those jobs if I don’t have the money to pay them. Where am I getting the money? I don’t have it. I literally don’t have it. … The day of reckoning has arrived. That’s it. And it’s gonna arrive everywhere. Timing will vary a little bit, depending upon which state you’re in, but it’s comin’.”

But if You Think California and New Jersey
Are in Bad Shape, Wait Till You See Illinois!

60 Minutes also interviewed Illinois state paymaster Hynes — a man who currently has about $5 billion in outstanding bills in his office and not enough money in the state’s coffers to pay them.

Care to know how far he’s behind in paying his bills?

Six months — precisely the situation I witnessed decades earlier in Brazil.

And care to know how many people are clamoring for the money? Consider his response to that precise question by the 60 Minutes interviewer: “Tens of thousands if not hundreds of thousands of people waiting to be paid by the state. Pretty much anybody who has any interaction with state government, we owe money to,” Hynes said.

That includes:

• University of Illinois, which is owed $400 million.
• Small businessmen, such as Mayur Shah, who owns a pharmacy in Chicago and has been waiting months for $200,000 in Medicaid payments.
• 2,000 not-for-profit organizations that are owed a billion dollars by the state.
• And many more creditors.

The big problem:

The more the cities and states slash their budgets … the more it sinks their local economies … and the more additional cuts they have to make.

Governor Christie of New Jersey, for example, cut his budget by 26 percent. He cut billions to schools. He laid off thousands of teachers. He cut another 1,300 state workers. He drastically reduced funding to cities, counties and villages, all in trouble themselves.

Yet, despite all those cuts, New Jersey is STILL facing another $10 billion of red ink in 2011.

And that’s just the immediate problem. Long term, say 60 Minutes and many analysts, it’s much worse. In New Jersey alone — $46 billion in unfunded liabilities to pensions and $66 billion in unfunded liabilities for health care.

Sound familiar? It should. Because it’s happening in states all across the country — and it parallels two looming disasters at the federal level — Social Security and Medicare.

How and When to Buy Tax-Exempt Bonds

Brokers will tell you: “This bond is triple-A. It’s insured. So don’t worry about it.” The main point I’m making today is that you should worry about it. The broker is getting his money out of the deal now. But will he be around to help you get your money out if these bonds go sour?

You suffer the worst losses when a city or state defaults. But the situation doesn’t have to reach that extreme before it begins to cause damage to your portfolio. Indeed, any downgrades will force the market value of your bonds down.

Suppose you need the money for an emergency. Suppose you want to use it for a better investment. Or suppose you want to get out precisely to avoid the possibility of a default down the road. Regardless of the reason, you may have to take a severe loss to do so.

So how do you buy tax-exempt securities? Well, if you feel you must have some in your portfolio, here are some of the steps I recommend:

Step 1. Avoid all unrated municipal bonds. Don’t fall for the argument that the extra yield on a “diversified portfolio of unrated bonds” will cover the extra default risk. This is the same argument that was made about junk corporate bonds. But then junk bond default rates surged, and they were proven wrong.

Step 2. Avoid all low-grade municipal bonds. Although I believe that the rating agencies are often biased toward giving higher ratings than the municipalities deserve, there is still a value in considering the ratings.

This is because, despite any bias, there is still a correlation between grade and quality. In other words, on average, a triple-B bond will indeed be inferior to a triple-A bond. I recommend only AA or higher.

Step 3. If you must have tax-free yield, stay short term. You can use (1) highest grade short-term municipal issues or (2) short-dated muni bond ETFs.

Step 4. Stay on the alert for major buying opportunities in the future. The best time to pick up bargains — and lock in high yields with safety — will be precisely when all of the weaknesses I’ve told you about this morning finally play themselves out.

A friend of my father’s, Ed Ball, was once able to pick up muni bonds in Florida during the 1930s for 10 cents on the dollar. When the market recovered just half way, he made profits in excess of 400% in a very short period of time.

Even if the municipal bond crisis is only half as bad, you are bound to enjoy major buying opportunities. So for the bulk of your money, I suggest you wait.

Good luck and God bless!

Martin