Tuesday, March 04, 2008

What the hell is going on with munis?

To understand what's happening in munis, and why its got so many people worried, you first have to understand how it used to work. You know, way back in early 2007.

When a municipality wanted to do a bond issue, they would hire an investment bank, who would normally invite other investment banks into the deal to help sell it. Not unlike what happens with corporate bond or even equity IPOs. The lead investment bank would decide on an interest rate it thought was the right level to sell the bonds. They'd set the level a little higher than the market, in the hopes of selling the deal quickly. Remember that a municipal bond issue is underwritten, meaning that the investment bank has committed to buy the issue from the municipality, and is taking the risk that they can sell the deal to the public.

Way back in early 2007, that risk seemed like no big deal. If a bond deal didn't sell in its entirety, the dealer would just put the bonds out on its retail system and sell them to mom and pop $5,000 at a time. Given the underwriting fee the investment bank earned, the risk of holding low volatility municipals for a week or so made a lot of sense.

Fast forward to today. Investment banks are generally strapped for capital. What capital they do have is not being heavily allocated to a low margin area like municipals. And a lot of the dealers' municipal capital is tied up in auction rate bonds.

So what happens when an investment banks is trying to underwrite a municipal deal but have been told not to use any of the firm's capital? They have to "pre-sell" the entire issue, meaning that the bank's customers have committed to the deal before the official sale. No big deal, right? Just set the price a little higher than the market, just like muni underwriters have been doing for years, and demand will come, right?

Well, not so fast. New issue muni supply is extremely large right now: over $8.4 billion in new issues are expected next week. A lot of that is auction-rate securities being refinanced. On top of that, there has been consistent selling from various municipal arbitrage strategies, such as tender-option programs. These strategies have been squeezed by bad hedges and insurer-related downgrades, and are currently flooding the market with bid lists.

Normal muni demand from mutual funds, insurance companies, and mom and pop investors just can't keep up with that kind of selling. And with dealers unwilling to inventory bonds themselves, that means that they have to make new deals so cheap as to entice non-traditional muni buyers into the market. In other words, vulture investors. The same people who have stepped in to buy auction-rate munis yielding 8% are now being invited into the fixed-rate muni market.

What's the result? Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50's. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt. Dozens of large new issue municipal deals came at significant spreads to Treasury rates.

The hedge funds are smelling blood in the water, and are moving in quickly. I've heard from multiple sources that non-traditional muni buyers, from hedge funds to taxable bond investors, lifted everything in the street yesterday. That's good news and bad news of course. It means that the muni market is indeed clearing. But it also means that muni rates can't move substantially lower (at least versus Treasury rates) until we get through this glut of new issue supply created by auction-rate refinancings and arb selling. These vulture investors don't really represent new demand for munis long-term, merely that if the street is going to absolutely give away municipals, there are buyers who will take them.

A trader I talked to today told one of his hedge fund clients that municipals were feeling like a falling knife. The customer responded that the ABX index was a falling knife. This is at worst a butter knife.


Ben Bittrolff said...

Good thing banks aren't f'd. Oh wait.

Really Scary Fed Charts: March

Anonymous said...


I know you've mentioned this time and again (in your discussions on ARS) that the problem has been with the bond insurers and not with the munis themselves. But the more I read, the more I hear about risks of munis failing in the coming year. Here is one such article by Dr Roubini on the same


There has also been one municipality which is close to filing for bankruptcy (Vallejo) - details on CR's website.

What happens when a muni files for bankruptcy ? What happens when insurers who insured the muni are unable to pay for the interest or refund the principal ? These factors could also be perceived as influencing the rates in the market, right ? From my seat, I don't really have an idea of what is going on - and then realize it could just be the uncertainty which is causing the higher rates. Your reasoning of higher rates could also potentially be explained by - repricing of risk, uncertainty or any combination of those.

What are your thoughts on these ? Are munis likely to default this year ?

Also, I'm looking back at historical rates, and see that LT rates (30-year AAA muni) jumped as high as 7% way back in 1994. Any ideas what happened then ?

Accrued Interest said...

Muni Investor:

Here is the plain fact. Among bonds rated by Moody's, there has never been a general obligation issuer default. Never.

Consider the case of Orange County CA and the derivatives blowup. They did briefly default on some pension obligations, but everyone was eventually paid in full.

Now, I am certain there will be much more downgrades vs. upgrades this year. Munis are looking at reduced revenue for the next 3-4 years. But this has happened many times in the past without bankrupting anyone.

There is a serious problem in Jefferson County AL right now. Their Water & Sewer department was HUGE issuers of ARS, and they also bought a swap to artificially fix their rate. Now the swap is extremely expensive to reverse, and the resets on the ARS are killing them. S&P just downgraded them to B.

That will be a great test case. My bet would be they will wind up getting bailed out by the state. You can't politically let people go without sewer service. But we'll see.

Anonymous said...

Another superb post AI. Just superb.

And you are right. There will be more than a few "test cases".

I think that the temptation will be overwhelming to save the sewer service and screw the bondholders.

More specifically, isn't the big problem with defaults that the municipality will not be able to raise money in the future?

Don't I smell a Fed bailout there and bondholders with paper in the hands...and little else?

Accrued Interest said...

On a bailout... historically muni bailouts have benefited bond holders. Again, consider the Orange County situation, where bond holders were made whole. Or the NYC bailout, where bond holders were made whole.

I think if the Feds got involved in a bailout, they'd rather make bond holders whole. Otherwise you'd really scare the hell out of the muni market, which would piss off local politicians, and thus flood the House and Senate will phone calls from state houses and city halls all over the country.

I believe that property taxes in California are only reassesed when a house sells. I wonder what happens if its repossesed?

Anonymous said...

Ignore the spread over treasuries for a moment. A yield in the 3.50s is a yield in the 3.50s, however you slice it. And Bernanke has made it about as clear as he possibly could, short of holding up a sandwich board with giant lettering, that he's going to let inflation run its course. This trade will not look so brilliant in a few years time.

Anonymous said...

So yet another person quotes spreads to Treasury rates and concludes that whatever spread product *MUST* be cheap.

What about the other interpretation? It could also be that Treasuries are over-priced.

First, you have a market situation that can only be described as total panic. Paranoid portfolio managers will (over)pay any price to get a Treasury, because not showing a nominal loss is the easiest way to avoid losing ones job.

Second, even though Treasuries are normally one of the most liquid instruments in the U.S. (and world)-- every dealer I talk to says volume is WAY off compared to a year ago. Balance sheets are impaired and Fed rate cuts are fully priced in so upside is limited. Selling treasuries to buy spread product, however prudent on a historical RV basis, is not something you want to defend before an investment committee. 1.5% return may be pitiful, but its better than anything with a negative sign in front of it.

However wide spread product might be, until the credit "freak out" is over (and balance sheets re-inflated) -- the spreads can easily get wider.

By the way AI, the FX market is far more liquid than Treasuries (even in normal times) -- and it is saying the dollar is mud. Deflation made the Japanese yen appreciate-- each yen worth a bit more than it used to be. The US dollar by contrast, is heavily depreciating -- as in INFLATION.

Commodities are also pointing to inflation. So is the fact that costs- everything from groceries to mass transit- is rising much faster than GDP (or Treasury yields).

Everything is pointing toward inflation, including the need for Bernanke to continuously deny it is happening. If the man had any credibility left, the question would have been dropped by now.

Two year Treasuries at 1.6% is evidence of a risk averse panic -- not deflation.

We all know that munis historically do not default -- just like we know that house prices historically only go up-- DOH!!!!

Michael Krause said...

So whats the hedge fund trade? Short treasury futures, long muni's of matching maturity ???

Anonymous said...

As a retiree I am really, really interested in inflation.

What is wrong with this scenario:

The reason, for example, that the Euro has taken off like a rocket ship is that the Fed has expanded the money supply of dollars with a fire hose. I believe the M2 figures bear this out.

But the question is: can this go on?

I would say that it could only as long as Americans, in whatever guise, continue to accumulate debt.

So isn't that the real question: will Americans continue to accumulate debt?

In that vein (so to speak) there are those who say that the only thing that really got us out of The Great Depression was WWII.


I would say that we're about to end a war, not start one. In addition, we have been taught by Reagan etc. that government is bad. So massive public works spending is not a really big possibility.

Oh, and everyone says that Social Security and Medicare are bankrupting us.

So that leaves the consumer.

Guess what folks? The consumer is yesterday. He's unemployed. His wife works. His house is underwater. And gasoline costs $4 a gallon. I'm sure the only thing on his mind is going to the Gap.

Accrued Interest said...

Certs: All I'm saying is you can't claim that the market is overly concerned about inflation when the 2-year is yielding 1.55%. I mean, I agree whole heartedly that Tsy's are overvalued, but as you are saying, until people get back into a "return on capital" mode, Tsy are going to stay over valued.

Anyway, munis are flying right now. The hedge fund trade is mostly to go long munis and short some taxable product, like Tsy or Tsy futures or swaps or whatever.

Anonymous said...

great column,

Mondays's post stated "Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50's."

What is the highest yield (pre-refunded 5 year) that you see today? How can I do a search of highest yielding prefunded bonds being offered? New issues would be preferred. I live in a state with no state tax so the municipality issuing would not matter. Thanks

PNL4LYFE said...

AI: regarding CA property taxes, they only reset when a home is sold. For existing homeowners, the annual increase is capped at something ridiculous like 1.5%. But I don't think this will be a huge issue since most of 'problem' houses are ones that were bought recently. The exception would be large cash out refis (not a rare exception).

Even then, I'm guessing foreclosure doesn't trigger a reassessment; doesn't the bank technically hold the title as long as the mortgage is outstanding? If they reposess, does that count as a transfer of ownership?

Anonymous said...


Do you know how to find the details of what has been escrowed on ETM and pre-re bonds? I can find the general classification on bberg, but, for instance, if it's st and loc gov't securities, I'm not sure where to go to find what the details are.



not sure if this helps, but auto lenders retain the title until it's paid off.

Anonymous said...


I'm a little confused by your example of Jefferson County AL. You said that they "bought a swap to artificially fix their rate" and that now "the resets on the ARS are killing them."

I don't understand how this could be. How could they have fixed their rate with a swap and yet have resets affecting them?

Anonymous said...

Some of my musings on the muni v. Treasurys relative value trade. Also presents a new way to do insurance by municipalities forming a coop to self-insure.


Anonymous said...

The more things change the more they stay the same:

1) Munis have call provisions. Any MBS/corp trader will tell you how 'easy' it is to hedge such an instrument with straight Treasury securities.

2) The 'spread to Treasury' argument invariably ignores the bid/offer and liquidity considerations. I've seen bid/offers as wide as 5 points on munis.

Accrued Interest said...

If you do a floating to fixed swap, to artificially fix a floating obligation, the inherint assumption is that your floating obligation will act like the floating side of the swap.

The floating side of the swap was somehow tied to LIBOR, but the resets on the ARS are much higher. So they are getting squeezed. Does that make sense?

Anonymous said...


Thanks for your patience with me, but I'm pretty new to this stuff. I thought the point of a swap was that someone else pays your interest obligations and you pay their oigations. So why doesn't someone else have to pay their ARS reset rates?



TallIndian said...

The Jefferson County structure works like this:

Jeff County issues munis with floating rates based on an auction or tied to a muni index

1) Jeff County pays the dealers a fixed rate (say 4%) for thirty years

2) The dealers pay Jeff County 65% of 3 month LIBOR

The theory is that rate Jeff County at worst the most they will have to pay on their muni debt will be 'close' to the 65% of the LIBOR they receive on the swap

Instead, now, they are paying a mulitple of LIBOR (3x, 6x, 10x) on the Auction Rate Notes and getting a fraction back from the dealers. Plus they have to make the fixed rate payment!

The basis risk is apparent but the Jeff County didn't see it until it was too late!

Anonymous said...


Thanks. I got it now. Crystal clear.