On Munis, Ratings And Contrarianism

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We get called contrarian often enough that we’re nearly resigned to the label. From our perspective, of course, we’re not contrarians at all. We’re so deficient when it comes to having a decent respect for the opinions of mankind that we aren’t even aware of the prevalence or rarity of the positions we take. If we seem contrarian, we suspect it’s just because so many others are wrong so often.
The debate over municipal bond ratings is a good example of this. Over at Portfolio—published out of an august tower located in Times Square—they are convinced that Moody’s, Fitch and the like assign ratings that are too low to municipal bonds. This supposedly forces our towns, cities and states to pay higher interest rates or purchase bond insurance to achieve higher ratings. Jesse Eisinger, who holds the esteemed title of Senior Writer at Portfolio, estimates that this costs municipalities around $5 billion a year.


Like so many other errant theories about the world, the Eisinger Thesis (as we’ll call it) starts with a grain of truth. Municipal bonds do get lower ratings than their chances of defaulting would earn them if they were corporate bonds. The ratings agencies acknowledge that munis are rated relative to other munis, and will even provide ratings for munis on the corporate scale if asked. Few municipalities do request this, however, because investors in municipal bonds are interested in risk comparisons between different members of the muni asset class and not so much in comparisons to corporate bonds .
But from this grain of truth, the Eisinger Thesis attempts to build an imaginary sandcastle of scandal, mispricing and collusion. What’s so implausible about the Eisinger Thesis is that it requires us to believe that the markets are radically inefficient when it comes to pricing municipal bonds. It asks us to believe that bond investors are unaware of very public facts—including the use of different ratings scales and the fact that the ten year cumulative default rate of muni bonds rated Baa is less than that of AAA rated corporate bonds. Only by assuming that investors are ignorant of these facts can Eisinger conclude that muni bonds are mispriced.
You can see the absurdity of this. Even if the unwashed were a ignorant as Eisinger believes, surely the publication of this alleged mispricing in a prominent business magazine should help alleviate the predicament. How notorious does a widespread error have to be before we can conclude that it is well known enough to be taken into account by the markets?
We’ll give the last word, however, to James Bianco, the president of Bianco Research and himself a famed contrarian. He agrees that the Eisinger Thesis depends on the belief that markets are radically inefficient for muni pricing. He departs from us only by embracing that belief.
“The market has been mispricing munis for decades based on the assignments of the rating agencies. If the market was properly pricing munis, bond insurance would not exist. It exists because this market is highly inefficient,” he writes.
Can it be that we've gone so far over the edge of contrarianism that we're contrary to the contrarians? Does that make us spokesmen for the conventional wisdom? If DealBreaker is conventional wisdom, things are far worse than we feared.

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