By: David A. Smith
Long, long ago, I learned that business operates by different rules than does society. In social settings, asking direct or personal questions can be rude or offensive, but in business, it’s par for the course.
“Sal, it’s not personal, it’s just business.”
So it is with the emerging market in Credit Default Swaps (CDSs), a combustible financial elixir that nevertheless has its uses, whose value in the marketplace seems to be willfully escaping the awareness of state and local officials. As reported in The Wall Street Journal [December 21, 2010 – Ed.]:
Some of the world’s biggest banks are lining up to profit from worries about the declining finances of U.S. cities and states.
Actually, that’s a double imprecision, one for each loaded word:
- Profit. More than likely, the banks already hold significant US municipal paper, so buying CDS’s against it is a form of ex post facto insurance.
- Worries. Payoff occurs not from worry, but from actual default – and that should be in the state’s control, shouldn’t it?
California governor-elect Jerry Brown, left, meeting on California’s budget earlier this month. With him is state controller John Chiang.
Imagine you’re a pension fund manager or advisor. One evening, you and your buddies went out for a night on the town. You were flush with cash and there were all these tempting offers – certified safe, you know, government licensed and everything, that’s how they do it.
Hey, there, how big is your endowment?
So you indulged. You took the plunge. Now you’ve put all that money out, and you’re getting worried. You’ve got signs of a nasty infection.
Investors are jittery about the municipal-bond market, providing ample volatility for swaps users to trade around. Many bondholders had long assumed local governments would never have a legitimate fiscal crisis because they could continue raising taxes to cope with the costs of servicing their debt.
What had been safe is now unsafe – and there is no way to undo the past. Wouldn’t you want to buy protection?
For the first time in two years, Switzerland’s UBS AG has begun making markets in derivatives tied to municipal bonds and other securities. The credit-default swaps obligate swap sellers to compensate buyers if a municipal issuer misses an interest payment or restructures its debt.
Often lost in CDS discussions is this simple truth: anyone who buys a CDS loses money if the state doesn’t default. Jitters by themselves bring no yield, any more than insurance pays off absent a loss.
After 17 consecutive weeks of inflows into U.S. muni-bond funds, including exchange-traded funds, the last five weeks saw $9.1 billion of outflows, according to data from Lipper, a Thomson Reuters unit.
The markets are scared – and rightfully so.
The sky is falling
Risk premiums on triple-A-rated corporate debt over risk-free government debt have declined by 1.22% over the past month, according to Bank of America Merrill Lynch index data, but risk premiums have climbed 14.3% in the case of triple-A muni debt.
Decrypted, that sentence speaks volumes. Highly rated corporate paper is seen as marginally safer (risk premiums are narrowing), but highly rated municipal paper is moving the other direction – it’s being seen as riskier.
Likewise, insurance on a default from California and Illinois, two of the most commonly quoted CDS contracts, has become more expensive. As of Monday, the cost of protection against a California default was 295 basis points, or hundredths of a percentage point, equivalent to $295,000 a year for 10 years of insurance on $10 million of bonds, according to Markit.
The last time we saw this movie, it was entitled Greece
A year ago, the same protection was $253,000. The cost of protecting that much Illinois debt was around $318,000 a year, compared with $161,000 a year ago.
Let’s put this in real terms. A quick check (accessed 31 Dec 10) of long California municipal bonds shows coupon rates of 4.75% to 5.25%. Take 2.95% off the coupon rate (for the cost of insurance) and you have a current yield of 1.80% to 2.30% (tax-exempt), versus a 3.4% taxable Treasury (accessed 31 Dec 10). Net out a 35% Federal and 5% (typical) state tax rate, and the Treasury yields you 2.04% — smack amidships of the credit-enhanced tax-exempt yields.
Governor – about that insurance you wouldn’t let us buy …
The markets, in other words, are much more rational than the hysterical state executives.
The only paroxysm to have, my dear, is a hysterical one
Separately, five large derivatives dealers—Bank of America Corp.’s Bank of America Merrill Lynch, Citigroup Inc., Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and Morgan Stanley—met last month in New York to discuss standardizing the paperwork for “muni CDSs” in an effort to attract more buyers and sellers.
Believe it or not, the bankers are acting responsibly. They foresee the municipal debt markets seizing up – in much the same way Fannie Mae and Freddie Mac’s liquidity markets nearly froze up two years ago – and they are trying to create CDS lubrication to keep the markets functioning.
This is dangerous territory to enter, because the CDS buyers will collect payments on a default, so CDSs can encourage the creation of default-goading wolfpacks — but the financial world is so much different than it was three years ago that I think default mobs are impossible, at least for a half-decade, and right now that’s the critical interval.
The issue is politically explosive. States and cities are suspicious of CDSs, saying they encourage speculators to bet on, and at times worsen, states’ financial distress.
Yes, a speculator can buy a CDS – but so too can a bondholder that already has the risk, and wants to rebalance the risk. Unlike 2007, when speculators dominated the corporate-CDS market, the muni-CDS market is unlikely to be dominated by speculators. Too much has happened in the interval.
California is about to require all 86 of its underwriting banks to disclose what CDSs they have traded on the state’s debt, either for customers or for their own accounts.
That makes perfect sense. Better and fuller information can only help – not so much the economic markets, which have already concluded the states are insolvent, but it can help the elected officials come to grips with the fool’s paradise in which they have been living.
“Think we’re in trouble, Bill?” “No chance, Ted.”
Just as states grow fearful of more muni CDS trading, federal regulators are trying to streamline and bring more transparency to the derivatives market, which may have the effect of expanding the number of muni CDS contracts outstanding.
Transparency and deep markets go together, and both of them use market power to compel change. We saw this with the Greek and Irish bailouts, and the continuing slow disintegration of the Euro. Key to the CDS market is that the counterparty must be collectable – if the borrower defaults, then the entity from whom you bought the insurance has to pay off. For that, the markets need stronger requirements for transparency and collateralization.
“There is no evidence that CDS trading has provided any benefits to the municipal-bond market, and further we have seen little evidence that it serves much purpose beyond allowing speculators to get rich,” said Tom Dresslar, spokesman for the California state treasurer’s office.
Oh, pfui. California’s bond markets are about to seize up.
The total value of CDSs written on California grew 35% in the last year, according to Depository Trust & Clearing Corp., but on a net basis—reflecting the actual exposure once buy and sell contracts have been offset—declined 5.8%.
That people are selling CDSs is, in its way, the most encouraging sign. It means people know California’s going to default; they’re trying to minimize or hedge the losses to themselves from doing so. There’s only one way the CDS’s could contribute to the default – if they heighten the perception of state insolvency and so make it harder for the state to sell bonds. But if the market is right, and the states are bust, as we think, then aren’t the states committing a bigger fraud by continuing to sell paper they cannot possibly repay?
If I were the Attorney General, I’d be investigating fraud, wouldn’t I?
The size of the municipal CDS market is about $50 billion, making it relatively tiny compared with the size of the overall municipal-bond market, which is $2.8 trillion.
Right, it’s two-tenths of one percent – that is, $1 of CDS for every $56 of municipal bond debt. The tail is not going to wag this dog.
If the tail were smarter, it would wag the dog
CDSs can be purchased to protect against a problem with a single municipal issuer, or on an index tracking a basket of 50 states, cities and other tax-exempt issuers. That derivatives index, called the MCDX –
Not the year 1410 …
– and administered by CDS pricing service Markit, includes a range of municipal obligations, including bonds used to finance public projects like local retirement communities and schools.
Bonds with specific collateral against them are a different story from state general obligation (GO, gee-oh rhymes with clio) bonds.
Large-scale municipal defaults are rare –
The collapse of Lehman Brothers was rare. The conservatorship of Fannie Mae and Freddie Mac was rare. The Greek and Irish collapses were rare.
Rare is a cut of steak, not a market phenomenon
– and losses are more likely on nontraditional debt, such as economic development bonds –
Gravy is a seasoning, not an exposition
Good gravy, what illogic. Economic development bonds have historically had higher defaults because, back in the Before Time, state finances were stronger than specific projects, so states carved off their riskier issues into specific economic development issues and collateralized them with the property and certain cash collateral. Now that the state’s finances are inverted, the risk is diametrically reversed – I’d much rather own a bond secured by a paying income-producing asset than a California GO bond.
Would you rather own this?
– than the general obligation and revenue bonds that constitute the bulk of the market.
Muni CDSs are still thinly traded because the contracts are highly customized and difficult to unwind. Two-thirds of muni-bond buyers are households and individuals investing through mutual funds, who don’t use derivatives. Hedge funds, meanwhile, are muni CDS buyers.
They’re buying the CDSs because they have cash to invest, and the major institutions, who already hold billions in municipal bonds, are over-exposed.
I’m kind of like to reduce my exposure about now
“In the spring, when we saw muni CDS costs start rising, we found out it was hedge funds trying to profit from a muni disaster,” said Jeffrey Cleveland, senior economist at Los Angeles money manager Payden & Rygel. “They’re looking for the next subprime.”
Well, that’s unscrupulous but not illegal – and the hedge fund positions are not big enough to influence the disaster. They’re just trying to spot it, and they undoubtedly expect to retrade and renegotiate their contracts after the impending default.
Those selling muni CDSs declined to comment on the record. But they say that despite being a target of politicians, their instruments don’t control the market; they only reflect it.
“By improving the liquidity and transparency of the municipal CDS market, it will improve the secondary market pricing of municipal bonds and that ultimately helps borrowing costs for issuers,” said Lary Stromfeld, partner at law firm Cadwalader, Wickersham & Taft, who has been retained by the banks to advise them on standardizing muni CDSs.
This is a worthwhile endeavor, because municipal bankruptcy is coming soon.
Vallejo, Calif., is reorganizing in a rare municipal bankruptcy, and Harrisburg, Pa., last week joined the state’s oversight program for distressed cities amid calls for it to file for bankruptcy, too.
It may well take at least one state going bankrupt to sober up the others.
Consider this a cautionary tale