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Municipal Bond CDS: Friend or Foe?


Credit-Default Swaps: A term not heard very often by the public but is, instead, increasingly growing with anticipation for many investors- some would even say growing in fear.

Credit default swaps, or CDSs, are insurance-like contracts between banks that insure against default on a loan or bond. CDSs are credit derivatives of either corporate or municipal bonds, and like insurance, they offer collateral in the form of premiums to offset risk. This difference between collateral and risk is the “spread”, and therefore, the spread is the trade or swap. For further explanation on the complete makeup and history of credit default swaps, read “Credit Default Swaps: From Protection To Speculation.”

CDS contracts can also be used to provide protection against a sovereign nation, mortgage payers and structured investment vehicle borrowers. Not surprisingly, mortgage-backed credit default swaps were at the heart of the financial crisis of 2007 (many argue the very cause of the economic downfall). Corporate giants like Lehman Brothers, Bear Stearns and AIG collapsed, or nearly in the case of AIG, due to this financial tool.

Currently, many see municipal CDSs as the new looming threat to the U.S. economy.

Municipal credit default swaps were created in 1998 but didn’t take off until 2003 and then significantly increased in trade in the spring of 2007 according to Barclays Capital. While the size of the municipal CDS market –or Muni-CDS, as they’re more commonly called- is about $50 billion, the municipal bond market overall has amassed $3 trillion.

While there are several types of municipal bonds, they can be separated into two categories: general obligation and revenue. General Obligation bonds are backed by the general credit and taxing power of the state or local government issuing the bonds. Revenue bonds are used to finance specific projects and are generally backed by revenues from the project. Failure-to-pay and restructuring are the only two credit events that will result in Muni-CDSs defaulting.

The credit-rating agency, Moody’s, reported in a 1970-2009 study that only 54 municipalities have defaulted-the majority of defaults were in the healthcare and housing project finance sectors- while 200 corporate bonds issuers defaulted in 2009 alone setting a record high for defaults in a single year. Furthermore, while a few muni bond issuers have defaulted due to operating losses or tough economic recoveries, only the town of Vallejo, California has filed for Chapter 9 as of 2008. Many towns are attempting to take measures such as tax increases to prevent more bankruptcies from occurring.

Although defaulting by a municipality is uncommon, state and local governments are becoming more and more suspicious of CDSs because they say that investors are being encouraged to speculate. As banks are underwriting Muni-CDSs, they are also informing investors, “who are tuned in to the “widely known municipal budget struggle” can now use derivatives and other financial mechanisms to sell short Build America Bonds,” reported in the New York Times quoting a Citigroup analyst.

Stated in a January 2010 presentation by the California Treasury Department, short-positions in state and local general obligation credits have been established to hedge against:
• Worsening fundamentals in municipal finances (falling tax-receipts, budget shortfalls, OPES liabilities, and infrastructure borrowing)
• Slow-down in housing markets (CA, FL, NV)
• Lower industrial/automotive production (MI, IL, OH)
• Declining profits in the financial sector (NYC, NYS, NJ, CT)

As a result of increased hedging against risk, the Wall Street Journal noted in a recent report that 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- recently met in order to devise a plan to make trading with muni CDSs more simplified by standardizing the paperwork involved. The article also reports that, “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.”

So much fear is culminating, in fact, that California State Treasurer Bill Lockyer wrote letters to its underwriters asking why they were selling short California’s $10 billion short-term revenue anticipation notes. With fear brings questions, and many are beginning to question the practice of short-selling in particular to the selling of the Build America Bonds, a federal government subsidized program.

The I.R.S., also, is taking a closer look as well. The same New York Times article noted previously that, “It is asking states for information on how the bonds were priced after some traded at significantly higher levels shortly after being issued. That could cause municipalities to pay higher yields than necessary.”

Moreover, several publications have supported the notion that muni bonds are being rated too low by credit rating agencies by “purposefully over-stating the risk of muni bonds in collusion with [Las Vegas] monoline bond insurers in order to force cities and towns to pay for bond insurance to get better ratings.” It is also suggested that “If rating agencies properly assessed them according to investors’ true risk of loss, muni bonds would have lower interest rates without the expense of insurance.”

On the other hand, credit agencies would argue they have fairly rated such bonds. In early 2010, Moody’s and Fitch Ratings revamped its rating structure for US municipalities by comparing them to other global credit sectors. The argument for this is to rate them on a broader scale in order to prevent unnecessary debt costs. Reuters reported that, “As a result of Moody’s move, some state ratings were lifted by as many as three notches. California, which led the charge to create a global scale, was bumped to A1 from Baa1.” However, Moody’s makes the claim that this recalibration only “represents adjustments to denote a comparable level of credit risk to other types of bonds, such as corporate bonds,” not as a means of reflecting “improvements in credit quality”.

Even though the muni bond market seemed to be doing relatively well with a lower one-year average cumulative default rate of just 0.01% versus 1.57% for corporate bonds, on October 11, 2010, local and state government issuers would suffer a major setback. The announcement of Moody’s reconsideration of a guaranteed investment contract provider caused the domino effect of other downgrades to follow.

In order to understand why credit rating agencies downgraded municipal bonds, we must take a further look into what led to it in the first place. Robert Kane, a bond portfolio analyst, explains it this way:

Here is what happened. Housing agencies and other municipalities sold bonds to raise funds for various projects. These funds were in turn invested in long term guaranteed investment contracts or GICS issued by the now troubled Pallas Capital Corp. The contracts were to pay between 3% to 5% annually. In all, Pallas Capital issued more than $614 million in guaranteed investment contracts to 53 state and local municipalities, according to Moody’s. Pallas was suppose to reinvest the proceeds into safe interest bearing instruments but instead invested into reverse repurchase agreements with their troubled parent, Depfa Bank. Moody’s downgraded Pallas GICs because “the GICs are a direct pass-through rating of the reverse repo counter party, DEPFA Bank,” who was recently downgraded on its own ability to pay back short term loans.

So, what is the outlook on the municipal bond market? Well, views are mixed.

Regardless of how the downgrading came about, some side with bank analyst, Meredith Whitney, that the muni bond market faces “deterioration” within the next several months. Many are watching cities like Detroit and Pennsylvania’s capital city, Harrisburg, for rising financial woes. While others, feel that the market will not go down in flames as some predict citing that as long as states raise personal income tax rates and Congress continue to provide subsidized bond programs, the market will sustain.

Lastly, credit default swaps are traded in the over-the-counter market and many are calling for them to be traded on a federally regulated exchange market instead to reduce the spread. This will increase transparency, improve the ability for investors to “gauge the liquidity” of the market, and promote price clarity. However, others debate that the creation of clearinghouses will not solve the issue. Critics say that the real issue is being confused with the counterparty risk involved in CDSs and a move towards the exchange market “may be the default response in times of crisis” rather than the solution.

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