Let's compare two companies, thinking in terms of credit-worthiness. Note that on May 1, 2008, credit-default swaps (CDS) on both companies were around 55bps. By way of comparison, CDS on the United States of America current trade at 67bps.
Company A:
- Is heavily exposed to residential and commercial real estate
- Has experienced an 18% decline in revenue over the last year
- Has announced massive layoffs
- However, is widely viewed as one of, if not the strongest within its industry
- CDS for Company A are currently quoted at 121bps
- Is heavily exposed to residential and commercial real estate
- Has experienced a 1% increase in revenue over the last year, although previous revenue forecasts had been for an increase of 6-8%.
- Continued economic deterioration will likely cause revenue to fall about 5% short of previous guidance in 2009
- Company executives have proposed a 1.5% price increase on their second largest revenue item to close this gap
- CDS for Company B are currently quoted around 400bps
I bring this up in response to Doug Kass' piece on "20 Surprises for 2009" and specifically #11: "State and municipal imbalances and deficits mushroom." (Actually its largely Roger Nusbaum's comment here that inspired this post.) Doug and Roger) are right. State and local governments tend to spend all they have every year. Few build up any kind of meaningful reserve during times when tax collections rise due to strong economic conditions. So when economic conditions turn, budgets become highly strained. This period is going to worse than past periods for a variety of reasons, primarily because it is hitting real estate values directly, which is a key revenue item for most local governments.
But the market is making a huge misjudgement in comparing the actual risks of large municipal issuers versus corporate issuers. Right now, the State of California CDS are trading wider than all but 28 of the 125 member Investment-Grade CDX index, indicating that most investment-grade corporations are less risky in terms of credit losses than the State of California.
Currently CDS on the Golden State trade similarly to CBS Corp, Southwest Airlines, and Rio Tinto. Yes, California is exposed to a bad economy, but the state has the power to forcibly collect revenue from its citizens! At 400bps, California CDS are wider than Carnival Cruiselines (358bps), Kohl's (293bps), Darden Restaurants (275bps) and Toll Brothers (206bps). Aren't all these companies just as exposed to weak economics? And aren't their revenue streams less diversified than America's most populous state?
Remember that the CDS should reflect the expected loss for all these companies. When a corporation goes bankrupt, debt holders usually wind up either selling off the pieces of the company for cash or becoming the new equity holders of the company in a reorganization. In bankruptcy, a firm's best asset is usually their real estate, but in today's market, commercial real estate certainly won't fetch top value in a liquidation. So corporate debt holders, generally speaking, are looking at historically weak recovery in a liquidation.
What could a municipal bankruptcy look like? Municipal debt holders would obviously not be foreclosing on the Governors Mansion. Instead, the bankrupt municipality would likely issue new debt to replace the old, defaulted debt. This might take the form of replacing existing debt at 5% with new notes with a 4% coupon. Even on a 30-year bond, an exchange of this type would only result in around a 18% present value loss. Even more benign would be to pledge a particular revenue source, such as a new sales tax, to a new debt series, then use the new debt to pay off the old debt. This is essentially what New York City did in the 1970's to avoid a default.
Note that California, like 48 other states (all but Vermont) are constitutionally required to pass a balanced budget. There is no option to just throw up their legislative hands and conclude that the citizenry won't accept more taxes. There is no option to say they'd rather pay the teachers and police than bond holders. Even if budget cuts and tax hikes become severe, governments will have no choice but to use all their resources to pay bond holders.
This isn't to gloss over the problems municipal issuers face. But it is far more likely that municipal bond holders will take losses on smaller, local issuers than states and (most) big cities. Take Vallejo, CA for example. That city of 117,000 filed for Chapter 9 in May. A small city like Vallejo is much more dependent on property taxes than larger governments, which tend to have a more diverse revenue streams. Plus smaller municipalities have less budget flexibility. Their budgets are usually dominated by education and law enforcement, where as larger issuers tend to have more fat to cut.
So here is my own surprising prediction for 2009: while municipal defaults will likely rise to a record number, losses to bond holders will still be relatively small. On top of that, muni bond holder losses will be dwarfed by those suffered in corporate debt.
(I own debt securities for J.P. Morgan and the State of California. No holdings in any of the other companies mentioned.)
18 comments:
Did you read about Goldman telling its clients to buy CDS protection against CA and other states? (Goldman being a major underwriter of the state's past bond issues....)
That's been a winning trade hasn't it?
I actually talked to the muni analyst at J.P. Morgan who made a similar recommendation. He didn't deny the basic facts that I've put forth here. But said that the psychology and technicals favored wider spreads.
So I'd say that wider CDS spreads aren't incompatable with my contention that actual risk of loss remains pretty low.
A good trade. An expensive hedge.
BT:
I completely agree.
The primary risk for CA muni bonds is not ability to pay off the bonds on schedule but willingness to pay off the bonds. Companies know that the bond holders can force the company into bankruptcy or even liquidation. The State of California can not be liquidated. If the bond holders get stiffed, the state will face financial difficulties but Arnold will still be running it, come Hell or high water (until his term runs out and the voters replace him with another incompetent bozo.)
AI - any thoughts on the MCDX?
The problem with MCDX is time. I think if you shorted (i.e. long credit risk) the MCDX you'd do great in the long-term. But if there is a real budget impasse in CA, MCDX could blow out in the short term.
Avant: I can't image a court ruling that CA can go into Ch 9 under current circumstances. In Vallejo, the unions are fighting the Ch 9 filing, claiming that Vallejo canpay but is unwilling. Clearly Vallejo is in far worse shape than the whole state. So the unions (and bond holders) would fight the same fight.
It's all about timing. I'm aiming to enter Cali bonds (11% discount to par last time I checked) right before Obama takes office. There is NO WAY he will let the world's 7th largest economy default.
AI, I did not like this post.
You seem very nieve about California's budget situation. Years ago the Democrats pushed through measures guaranteeing spending for education and services that make up 80% of the budget. Thus, for the past few years, "balancing the budget" means issuing enough bonds or financing measures to meet spending without regard to the impact to future budgets. Thus California is so indebted, and spending so constrained, that it is highly possible that the debt payments will outstrip our debt servicing ability in a year.
Unless that protection of the service spending is repealed by the spendthrift Democrat dominated legislature, the state is headed for default or severe pain.
Corporations have a huge advantage over governments in their organizational flexibility in scaling up and down capital spending. The California CDS reflect the disfunction of the state's budget gridlock.
California SEEMS indebted b/c of GASB 43 and 45 accounting provisions. But they can always cut entitlements (to govt employees) or alternately get the Federal government to pick up the cost.
Don't get me wrong, I am bullish on munis for a swing trade only. When inflation hits (and it will), fixed income will not be the place to hide.
Btw, is there any way a retail trader can short the MCDX?
Lock:
As I say, the government cannot choose to spend money on education and not pay bond holders. They cannot choose to not hike taxes.
If you want to argue that the CA situation gets worse before it gets better, that's perfectly fair. And honestly I'm not even arguing you should buy CA GOs. I was using that as an example of the worst of the states and how its probably not that bad anyway.
I think if you are a buy and hold investor, munis are a great spot. I wouldn't own much in local CA GOs, as well as New York area credits. Not because I think any of those are going down, but more because its a risk you don't need to take.
If you are trying to trade it, buy on dips. Right now probably isn't the best time to load up.
When is the ideal time to buy Cali bonds? Before or after the California reps start throwing chairs at each other over the funding crisis?
Hi AI,
This is a bit of a late comment but I was wondering what your take was on Buffett's warning about the tax-exempt bond market (made in his letter to shareholders this year).
This is the relevant quote:
"The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds.
Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.
A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.
To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems.
So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.
Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.
Local governments are going to face far tougher fiscal problems in the future than they have to date.
[...]
When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?"Though California has a constitutional ammendment, even these can be repealed, and many entities do not have them at all. In general, do you think the risk Buffett describes is credible?
Its credible, but truthfully there isn't a significantly greater history of muni defaults with insurance vs. those without. Jefferson County will be a major test of this.
Thanks AI. Has there been enough history of insured bonds for any default data to be statistically valid though?
If you mean the difference in recovery with an issuer who does mostly insured bonds vs. one that does mostly uninsured bonds, then no. Both are too rare.
If you mean the instance of default generally, then yes, there is plenty of data to show that insured bonds don't default at a higher rate than uninsured bonds.
You've inspired me to write a larger post on this subject.
The California state Constitution specifies that the order of payments is 1) education (about 50% of the budget), 2) bondholders (10% of budget) 3) state workers 4) everything else. Neither the legistators nor the stete trreasurer can change this. The state is also prohibited from declarinbg bankruptcy. Thus, unless you believe that the state will stop paying its workers, bondholders will receive their payments.
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