What if Wall Street were to trade municipal bonds like it did mortgages? Once the thought of trading a 30-year loan seemed preposterous, but during the last real estate bubble enormous vats of mortgages – mortgage pools, in some cases with unassigned terms or durations – were attracting blind bids like the mystery bag at a charity bizarre. Why not do the same with 30-year bonds?
On the plus side a heightened interest in munis could make the riskier local economies more attractive to seekers of higher yield risk products. Competition for them might even hold down interest rates for the governments. But we’ve seen a darker side to hot markets; the inclination to put the cart before the horse; i.e., to encourage government borrowing for the markets’ gain, sign up the least able to repay, create synthetic products with no connection to the underlying and to bundle it all into complex pools nearly impossible to unwind. Municipalities that don’t limit tax hikes to make bond debt payments can count on more favorable bond ratings than those who do cap. So borrowing is only limited by tax payers’ income, not the governments. One city clerk recently waxed nostalgic about the good old days of the 1970s when the stretch limos that bond counsels used would spirit municipal officials to NY law offices where the new bond issues were signed. The day would end with dinner and theater tickets, along with gin and tonics in the rear of the limo. The municipality in question was a 1.4 sq mile town with a per capita income under $20,000. Those luxuries seem to have vanished like the bond insurers. But insurance is back.
Insurance in the form of credit default swaps (CDS), previously used to insure mortgage backed bonds or to bet against mortgages getting repaid, are enjoying a resurgence as muni CDS. Investors buy muni CDS as bond insurance or to bet that a state or municipality will miss its debt payments and default on the bond. Wall Street loves muni CDS. Trading indexes of CDS really got moving just this past fall, according to Citigroup Global Markets’ ‘U.S. Municipal Strategy: Outlook 2011,’ which noted the market is “still in its infancy.”
Wall Street’s reaction isn’t surprising: risk markets thrive on uncertainty. With budget woes, including towns that can’t meet payrolls or whose pension funds are short money, US governments are providing more doubts and fears than “General Hospital.”
There is so much speculation on U.S. government debt that spreads on muni credit default are wider than insurance on corporate debt. Markit, an NY-based global financial information service company, measures credit risk with indexes of credit default swaps. Its MCDX index of muni CDS tracks a basket of 50 municipal issuers. On February 22, the MCDX average spread was 170 basis points, compared to the equivalent corporate benchmark (the Markit CDX.NA.IG) of 83 basis points. In practical terms that means to buy protection for a $10 million portfolio of municipal bonds using the MCDX would cost $170,000 per year. It also means that investors think Main Street is riskier than Wall Street.
In what they expect to be ‘An Exciting Year Ahead,’ Citi’s analysts Mikhail Foux, George Friedlander, and Vikram Rai describe how Wall Street can create a structure for trading muni bond debt, which is strikingly similar to the mortgage market of the last decade. First, muni CDS contracts have to be standardized to look more like corporate CDS, say the authors. The “conditions of the standard MCDS contract are being negotiated,” reads the Citi report. News reports confirm that a major law firm is negotiating the new contract form for major banks, including Bank of America Merrill Lynch, Citigroup, Goldman Sachs Group, JPMorgan Chase, and Morgan Stanley, who met to discuss the contract in NY last fall. Whether changing the conditions of muni swap contracts will have repercussions on the underlying bonds is yet to be known. Citi declined to answer questions beyond what is contained in the report.
Then the streamlined Muni CDS will be gathered into tranches and split into two categories. In mortgage instrument trading, mortgage debt was gathered into collateralized debt obligations (CDOs), sliced and sold as bonds with several levels of risk. It was these CDOs that CDS owners were buying insurance on. As has been documented, the demand to hold CDS came to drive the selection of mortgages to make up the CDOs. Mortgage writers were pressed to offer outrageous loans, some with negative interest, by unscrupulous firms that pumped the higher risk mortgages into more CDOs, which raised the value of the CDS. When the mortgages started failing, bond insurers went under and many CDS deals known now as ‘toxic waste’ are still rotting in the economy.
In the muni market scenario, Citi expects two tranches of MCDX: equity and senior to start trading next year, “when the $0.7 trillion muni derivatives market could see substantially more activity.” The report continues: “Since MCDX trades at a much higher spread compared to CDX IG [an index of 125 No. American investment grade corporate bonds], MCDX will likely trade at juicy spreads, potentially incentivizing protection sellers, especially for senior tranches.” Lower risk municipalities and states are likely to have smaller spreads. Will the attraction of juicy spreads prompt market players to encourage higher risk governments to take on more debt?
This is a particularly raw moment for the governments that issue these debts, since many are drowning in unsold, abandoned or devalued properties, which are depressing tax coffers at a time when residents may still be looking for work or being forced into layoffs or early retirement. If they once were civil servants, those retirees also may be draining state and local reserves where pensions are underfunded. For these governments, the Wall Street subprime frenzy lingers on the tongue. Most of the state governments contacted for this article declined to comment because they were unaware of the plans to trade muni bonds this way, one exception being California.
“I believe a lot of the speculation in MCDS is by people with no skin in the game,” says Tom Dresslar, spokesman for California Treasurer Bill Lockyer, who is demanding banks doing business with the State disclose their MCDS activity. “Banks always say [speculation] helps the issuers because it strengthens liquidity in our bonds. But I’ve yet to see any value in the MCDS market other than to benefit special interests and other investors – folks who buy, sell and trade the product.”
Dresslar takes particular exception to the assumption, in Citi’s report, that government recovery will be reflected in CDS prices, which he says may be too high. “It irks us,” he says. “The whole market doesn’t make sense. Governments hardly ever default and that’s not going to change – despite what Meredith Whitney [an analyst who correctly called Citi’s dive early in the credit crisis and this fall forecast municipal loan defaults] seems to think. The prices CDS imply as the default rate on muni bonds is so far out of the realm of reality it makes us question what the heck the market is about – to provide liquidity for the bond market or speculators trying to profit? It’s pretty clear from history what Wall Street’s intentions are.”
There are already casualties on this battlefield. Jefferson County, Alabama flirted with Chapter 9 with $4 billion in debt from issuing bonds and related interest-rate swaps, which dove in late 2007.
As markets mature they tend to get more complicated anyway and less easy for regulators and others to follow. The Citi report toys with some of the exotics. The swaps, it feels, are “not really a great hedge for bonds” because bonds aren’t all that liquid, and the underlying factors that affect the financial life of a government are fundamental and indexes are more based on charts and graphs. A whole other index that could accommodate day-to-day moves may work better from a market perspective. It could be more transparent than its first option, the MMD [or Muni Market Data Line] Interest Rate Lock index, too, something that might please regulators. But in the same discussion Citi introduces the likelihood of Tender-Option Bond [TOB] activity, the very mention of which raises the hackles of Charles Morris, author of the first book out on the credit crisis, ‘The Two Trillion Dollar Meltdown’ (Public Affairs). “They can lead to terrific volatility in returns and principal values,” he says. “Lots of people and even mutual funds got burned on them.”
Morris recalls the 2007 lawsuit filed by seven Norwegian municipalities and the now bankrupt Oslo-based Terra Securities ASA against Citigroup Global Markets. The plaintiffs alleged securities fraud related to the (TOB) fund managed by Citigroup. The municipalities, which lost $90 million, and Terra claimed that Citi did not convey the significance of the risk.
“TOBs involve investment banks splitting cash flows into different instruments,” says Morris, one is short term with a fixed rate, but the other is long-term and variable. He recalls the spring of 2009 hit that the Eaton Vance National Municipals Fund took when a $5.4 million, 30-year bond from the Virginia Housing Development Authority it was holding among its TOBs lost 52 percent. “Anyone who doesn’t make his living at this stuff shouldn’t touch it with a ten-foot pole,” says Morris.
It’s not an unreasonable comparison to make, between the credit crisis of the last decade and the muni market Citi envisions busting out next year, says Andrew Lo, a professor of finance at Massachusetts Institute of Technology’s Sloan School. “People are mostly focused on the muni market and not so much on the derivatives surrounding that market.” Lo sees striking similarities between the motivation for this market and the subprime market of the last decade, with effects on the muni world possibly harder to read. A muni equivalent of mortgage CDOs, “one could argue,” he says, “in the underlying bonds could be more complex – not mathematically, but in terms of trying to understand where the underlying sources of revenue are and whether lenders will get paid back. A bond whose payoff depends on payouts of a municipality, which depends on revenues from taxation that in turn rely to some extent on political wills are much more complex. The political process is not even amenable to mathematical analysis.”
Last time investors wanted to short an overheated real estate market. Now they see “municipalities are under a lot of stress financially,” says Lo. “A lot of bonds are getting issued; and they’ve had a hard time getting them paid back in the last year or two due to the recession and economic slowdown.” Lo believes it’s a natural market. “The CDS market is emerging because enough people want to bet against munis – that they’ll default – and enough others want to insure against default. They should be allowed to do that, but not in a way that threatens the stability of the entire financial system.”
And analysts are divided on that threat. “We have Meredith Whitney on one side with default probabilities and Pimco [Newport Beach, CA-based bond fund] on the other side saying everything’s fine. It would be nice to be able to profit from the wisdom of crowds,” says Lo, who is also chief investment strategist for the Cambridge, Massachusetts-based Alphasimplex Group, an investment firm that he hastens to add doesn’t deal in muni bonds. “But first we need a large market of participants willing to put their money where their mouths are and help us see what those prices will show. In order to do that we need the right structure for this one.”
The path regulators seem to be headed toward now, with standardized contracts, daily mark-to-market pricing, transparency as to what the exposures are and the default probabilities, could make for a healthy market, sources agree. Citi’s analysts want to see munis become standardized and centrally cleared.
A lot will depend on whether the market makers really foster information, from social and political factors to budget numbers. Morris points out that insurers supplied that function, not really rating agencies, in the last market. But they went bankrupt doing so.
At its best a CDS market with muni indices, tranches and structured instruments could spawn an atmosphere where spreads might reveal a lot about municipalities. “Instead of sending free lunches to Scarsdale,” says Lo, “the market may suggest more social programs are needed in Camden.”
Lo expects various instruments and derivative loans will grow, depending on who is allowed to play in these risky instruments, something he cautions regulators must be vigilant about. “If S&Ls or money markets start losing money that’ll be another story. These instruments will come back with a vengeance,” says Lo. “And I think we need them to grow in order for an economy the size of the U.S. to grow at a rate we can be proud of. To do that we need very large and robust derivative markets -- no doubt about that.” But Lo draws a distinction with derivative markets that “grow largely unchecked with no controls on the nature of the investors ... and whether they can withstand the kinds of losses likely to occur in a major downturn.”
The major players in muni CDSX will be hedge funds, Lo says. “There’s a lot of money sloshing round hedge funds. I wouldn’t be surprised if John Paulson [who shorted residential mortgage backed security CDOs with credit default swaps and made a fortune] put a large chunk of his very large fund into a bet against the muni bond market using these CDS instruments.”
We know the signs this time. It remains to be seen if they will they be ignored.
