Municipal Bonds: As clumsy as it is stupid

Municipal bonds are getting crushed again today. 10-year MMD was cut 13bps today after being cut 11bps yesterday. That's something like -2 points in price losses in two days. Closed-end funds are getting absolutely crushed. Traders I've talked to are blaming street selling. Here's what's been happening.

For weeks, the bid for munis seemed endless. Even as the ratio with Treasury bonds hit historic low levels, (75% on 10's) mutual fund flows were so strong and new issuance was so light that dealers couldn't keep bonds in stock. So they bid every competitive deal like a Correlian smuggler hitting on an Alderaanian princess.

Then all of a sudden the street found the level at which people just wouldn't buy. I'm not sure if fund flows have tapered off or if its just a buyers strike, but my bet is on the former. Now dealers are stuck with bonds in syndicate. If you are a dealer like Stone & Youngberg or R.W. Baird or Loop Capital (i.e., the regionals who are mainstays of the muni market) getting stuck with $20 million bonds really does matter to you. That's real capital that isn't making you any money. In fact, if you have to cheapen up your offering, it costs you money. You're taking losses on those bonds.

In other muni news, today we got two interesting BAB deals. The Crimson Tide vs. the Minutemen. Wouldn't be much of a match on the football field, and wasn't much of a match in the muni market either. University of Alabama brought a 2039 maturity (among others) with initial talk in the +220 area (that's 2.2% above 30-year Treasuries in yield). UMASS was talking +225 for the same maturity. 'Bama is rated Aa3/AA- while UMASS is rated Aa3/A+. Not really any difference.

Citigroup struggled to sell UMASS, even cheapening it up by 10bps. As I'm writing this, I don't believe the deal is done yet, after two days of selling it. Meanwhile Morgan Keegan had a food fight on their hands. Investors clamored for 'Bama, causing Keegan to tighten the bonds by 15bps. Many times over-subscribed.

So in the final analysis UMASS had to pay at least 30bps more in yield to sell their bond compared to University of Alabama. Why? Because no one trusts Massachusetts' budget. Note to politicians around the country. Your actions have consequences. That's real money UMASS is going to pay to bond holders instead of using it for education.

Finally, I heard today that the Nuveen Insured Dividend Advantage Fund (closed end) is selling $100 million of $10 par preferreds. This is intended to replace some of their existing auction-rate preferred bonds which have been stuck in limbo for nearly two years. Worth noting that its structured as fixed rate at 3% for 5-years (tax-exempt) with a premium call after 1-year. That's a hell of a rate! To my knowledge, CEF's never have sold fixed-rate preferred stock to fund their leverage in the past. It creates some risk that investment rates will fall below their leverage cost, but then again, they can call the damn things if they have to. If rates rise this thing would be a boon for the Nuveen fund. Look for all the closed-end funds to follow suit.

I think munis will come back, at least vs. Treasuries. We're now at a somewhat cheap 90% ratio on 10yr munis. I don't think anything has fundamentally changed and I don't think this sell-off has anything to do with credit fears. Problem is that it might be Treasury rates rising that gets the ratio back to 85% or so. Either way, I'm not going to jump in front of the train!

Disclosure: Bought the 'Bama bonds

Ever make your way as far into the interior as Coruscant?

I had the following debate today with an old muni master. Which would you rather own, assuming the same yield. Prince George's County MD, which is a wealthy Washington D.C. suburb, or New York City? Both came with BAB deals in the last two days, hence the debate. My friend took New York. I took Prince George's. Here's the low down on both.

• Population: New York 8.2 million, Prince George's 820,000
• Unemployment: New York 10.3%, Prince George's 7.5%
• Median Household Income: New York $38,293, Prince George's $55,526
• Case-Shiller Home Prices, last 12-mo: New York -10.35%, Prince George's (part of DC metro area) -9.78%
• Credit Rating: New York Aa3/AA, Prince George's Aa1/AAA

Here is the positives for New York over Prince George's. Obviously New York is a bigger economy with much more economic diversity. In addition, Prince George's bond issues have a fairly unusual "limited tax" stipulation. Typically a GO bond documents require the municipality to use their full and unlimited taxing power to repay bond holders. In a lot of cases, the property tax rate is determined by what is needed to fund debt service (as well as other government services). However, Prince George's has a limit of 2.4% of assessed value period.

Despite this, I like Prince George's better. First, much of the County's employment is based around the Federal government, which is the one part of the economy that is still growing. New York on the other hand is in the eye of the storm in terms of finance lay-offs. But more importantly to me, New York has a more complicated budget.

In reality, neither is likely to actually miss any bond payments. So the risk is a California-style budget battle, where the situation is unresolved for months and months causing spreads on bonds to widen dramatically. Isn't that much more likely to happen in the Big Apple? Prince George's just doesn't have a complicated enough budget to create this kind of problem. New York does. Hell, New York has gone through such budget battles multiple times in the past.

Anyway, food for thought among the muni guys in the audience.

Municipals: Your work here is finished

Here is a newsflash. The IRS isn't that bright. But there is a problem. I think they are cooking up a scheme that they think is going to increase tax revenue, but in reality is going to cost all of us more money without benefiting the tax coffers at all.


Its long been known that there is a certain contingency at the IRS and within Congress that wants to remove the tax-exception for municipal bonds. I've heard it time and time again from various sources. IRS hates munis. Here is their thinking. Municipal bonds are purchased mostly by the rich, who currently pay a 35% marginal tax rate. If there were no tax-exemption for municipals, the rich would be buying some other kind of bond, say a corporate bond, and paying 35% taxes on the income. So from the Federal government's perspective, they are missing out on 35% in taxes.


This 35% is basically a subsidy to state and local governments as well as many non-profits, particularly hospitals and colleges/universities. These issuers enjoy a lower interest rate on bond issues because the rich desire tax-exempt income. Let's put some numbers on this.

According to SIFMA, there are $2,726.8 billion in Municipal bonds outstanding. According to Merrill Lynch's Master Index, the average muni coupon is 4.69%. The Treasury department seems to think that if there were no tax exemption on munis, the average coupon would be 4.69%/0.65 (0.65 being the inverse of the 35% tax rate), or 7.22%. They would then tax you on the 7.22% coupon, adding up to $69 billion per year in tax revenue. Or so they seem to think. More on this in a moment.


Enter the Build America Bonds program. Under this program, municipalities can issue bonds with a taxable interest rate and receive a 35% subsidy on the rate. So for example, one of the first large BAB deal was for the University of Virginia. It sold with a coupon of 6.2% on a $250 million deal. Thus the Federal government will be writing a check to UVA for $5,425,000 every year until this thing matures in 2039.


The Treasury department seems to this this is no blood, because UVA was effectively getting a 35% subsidy anyway. Why not just pay them in cash? Ostensibly, the purpose of the BAB program was to open up demand for municipal securities beyond traditional buyers. If you remember back when the BAB program was enacted (February 17) the municipal bond market was in shambles. Demand from retail buyers, either direct or through mutual funds was non-existent. $14 billion had been withdrawn from muni mutual funds during the 4th quarter. The BAB program was supposed to help by enticing non-tax paying buyers, particularly pension funds and foreign banks, to buy muni bonds. That part of the program has worked brilliantly. BABs have become very popular among institutional investors. It has also constricted tax-exempt supply, which is a big part of why municipal bonds are so expensive currently.

But is there scum and villainy at play here? Are there those who want to see the BAB program made permanent and the tax-preference for municipals eliminated? Let's go back to the assumptions made by those who want to see munis die.

First there is an assumption that all municipal bond buyers are in the 35% tax bracket. But that is obviously false for a number of reasons. First, only about 1% of filers (or about 1 million returns) pay the maximum rate. Probably not enough to soak up the entire muni market. Its common for wealthy individuals who are no longer actively working to have very little traditional income, thus a relatively low tax rate. In fact, my wealthiest client has been stuck in AMT for several years. Some municipals are held by for-profit corporations, but this is overwhelmingly insurance companies who don't necessarily pay the maximum rate either. Insurance companies have notoriously variable tax rates, as they go through periods of higher or lower claims.

Evidence from trading history also suggests the marginal buyer of munis was at less than the 35% bracket. Here is a chart of the Muni/Treasury ratio since 2001.


You can see that during this period, municipals were never even close to yielding 65% of Treasuries, the theoretical break-even point. Somewhat closer is the Muni/AA Corporate ratio...
But even there, the ratio is usually in the mid-upper 70's. Only during a handful of periods (mostly when corporates got very tight, not when there was any change in tax policy) did that ratio fall into the low 70's.

So I think we can kill the first part of the theory, that the Treasury is suffering 35% in forgone tax revenue. Its probably more like 30%, somewhere between the 35% bracket and the 28% bracket. This is driven home all the more by fact that Build America Bonds are currently making up half of total municipal bond issuance. Currently municipalities can choose whether to sell bonds under BABs or to sell in the traditional tax-exempt market. As it is, almost all bonds issued longer than 15 years are going BABs. Why? Because the interest savings by going to the tax-exempt market is smaller than 35%. So municipalities are taking their 35% from the Feds!

Here is the first instance where I'll say this program is costing tax payers. If we want to subsidize local governments, its cheaper to just allow them to sell tax-exempt debt. Paying this direct subsidy is clearly costing federal tax payers.

Now let's say the conspiracy theorists are right, and the Treasury really wants to extend to BABs program permanently and eliminate the tax-exempt market. We've already seen that the 35% subsidy costs the Federal government. What about local governments? We all pay some sort of taxes to both the Feds and the locals. Does it really matter if we pay somewhat more to the Feds and somewhat less to our state/county/city/etc? It does if the municipality also winds up paying more!

If there were no municipal bond market, how would retail investors invest in the bond market? As any one who deals with individual investors knows, the answer is they will go where the yield is. Where will the yield be? Not in munis. It will be in corporate bonds, preferred stock, high-yield funds, etc.

Who will buy the municipals then? The same people who are buying the BABs! BABs have found ready buyers among those who traditionally had bought high-quality long-term corporate bonds. Once upon a time, these were buyers of AAA-rated names like AIG and General Electric. Obviously what was once thought of as a very safe, "sleep at night" bond is no longer considered as such. Many of those buyers have moved on to the BABs market, where you feel like you can sleep at night buying the State of Utah or the University of Texas bonds. You also have big mutual funds buying, figuring BABs are a good alternative to Treasuries for their long-term bond exposure.

On the surface this seems like no big deal. Municipalities sell the same bonds just to a different set of buyers. What's the difference?

It probably is no different if you are the University of Texas selling $300 million in bonds. Institutional buyers like that they can buy as much size as they want. But what if you are the City of Mos Eisley Speeder Parking Revenue Authority who wants to sell $10 million? Deals of that size happen all the time in tax-exempts. In the classic municipal market that was no problem because munis are often sold $20,000 at a time anyway. Retail buyers don't care about deal size. They care about name recognition. So the Mos Eisley Parking Authority sells bonds to the rich moisture farmers in the area who feel like they know and understand the parking revenues in Mos Eisley.

The big mutual funds, pensions, insurance companies, etc., don't "know" Mos Eisley. The only way they will bother to take a look at a smaller deal is if it offers much higher yields than similar (larger) deals. And if you are some lower-rated small issuer, like a hospital or private college, forget it. As an institutional buyer myself, if I'm going to really have to dig into a institution's financials and track it closely from quarter to quarter, like I would a Baa-rated hospital, I better be able to get large size to make it worth my while. So the local hospital who wants to sell $20 million in bonds to build an addition isn't going to attract institutional buyers at all, virtually at any price.

In the traditional tax-exempt market, a strong AA-rated revenue issuer, even if it were a small deal, would classically only be 10-15bps cheap to a state GO. If retail investors were taken out of the muni market and replaced by institutional investors, that gap is probably 50-75bps. Like I said, institutional buyers would have to be paid substantially to buy the small issue.

So let's do the comparison. On 9/16 the State of Utah just sold a 10-year BABs with a spread of 70bps vs. the 10-year Treasury. That came out to a 4.15% coupon. Thus the Federal government will be paying Utah 145bps of subsidy for a "net coupon" to the state of 2.70%. Conveniently, on the same day Utah also sold 9-year tax-exempt bonds at a yield of 2.68%. There is about 17bps in spread between 9-year and 10-year munis right now, so we can guess had Utah sold 10-year tax-exempts the yield would have been around 2.85%. 15bps of savings to the state by going with the BABs program.

Now let's take a high quality but small issuer who has to sell bonds 75bps wider than the state of Utah. Had they sold on the same day as Utah they would have had a spread of 145bps for a coupon of 4.90%. The subsidy would be 171bps for a net coupon of 3.18%. So earlier I assumed that same issuer could normally come in the tax-exempt market 15bps wider than Utah, or 3.00%. So if the tax-exemption were taken away and thus retail weren't around to buy up smaller deals, the smaller issuer would pay 18bps in higher interest that it would otherwise.

Now let's think about the wealth transfer here. Small issuer pays more in interest. Federal government pays small issuer, but not enough to make up for the extra interest cost. Federal tax payers pay more. Local government pays more in aggregate, which of course eventually hits local tax payers. Who wins in all this?

SMACKDOWN WEEK: I see a city in the clouds

MORE BEARISH: Municipals

MORE BULLISH: Foreign ownership of Treasuries

Municipals

There are a number of problems with municipals today. First let's get to the least often discussed: munis aren't cheap. On an absolute yield basis: (10-year muni rates according to MMA):




Now we know that general interest rates are low, but even on a percentage-of-Treasury basis, munis are at best fair value. From 2001-2007, the average 10-year muni/Treasury ratio was 86.9%. Currently its 90.2%. Hardly screaming value.


What about muni credit quality? My concern is two fold. First, municipalities are not very nimble. One of the big positives among corporate securities (stocks and bonds) has been their ability to rapidly cut costs in the face of falling demand. IBM can lay off thousands at a moment's notice. Anadarko can shut down oil rigs. Boeing can shutter plants.

But municipalities the proverbial Bantha trying to turn around in quicksand. A governor can't just unilaterally say the State needs to shut down certain programs. A mayor can't unilaterally shorten work hours. A county council president can't lay off unionized public employees. They literally don't have the power to do so, at least in the overwhelming majority of cases. They just can't react quickly to a changing revenue environment. Expense management is therefore a major challenge.

How bloated is state and local government spending? I'd generally say that local government spends what it has. So when revenues rise, no one in the state legislature says "Hey, let's save this for the next recession," unless mandated by law to do so. They spend it! What looks better to constituents? A nice new park or a larger "rainy day fund?" Politicians will pretty much always pick the nice new park.

Revenue is also going to be a continued challenge. There are four major areas of revenue collection for state and local governments. Residential property taxes, corporate property taxes, income taxes and sales taxes.

I'd argue that all four will either decline or at best be flat in 2009-2010. I'm going to assume, as is very common among state and local governments, that we're talking about a June-June fiscal year. So the 2008-2009 revenue figures would be based on economic activity during that period. Basically as the recession was really gearing up. Since June 2008:

• Nationwide home prices down 15.4% (Case Shiller Composite 20)
• Retail Sales down 9% (Census Bureau)
• Non-farm payrolls down 4.5%

So even if all four bottom out here (if you care, I think home prices will but the other two won't), all are starting from a weaker start. For example, if state sales tax started the 2008-2009 period at 100, its now 91 (i.e., a 9% decline). If the decline was evenly distributed during the year, the average collection would have been at a 95.5 level during the year. But for 2009-2010 we're starting at 91. Sales tax collection could bottom here and still collections for 2009-2010 would be down 4.7%. The same principal applies to property and income taxes.

Commercial real estate is likely to get worse before it gets better. That's a subject for another SMACKDOWN but suffice to say that commercial property taxes aren't going to be a source of revenue increases for municipalities for some time.

So we're likely to see continued budget problems in 2009-2010 and I'd think 2010-2011. Will there be large numbers of municipal defaults? Probably not. Large municipalities will figure out a way to pay off bond holders. In general, municipalities don't have the option of choosing to pay other expenses but not pay bond holders. A state legislature can't say they'd simply rather pay public employees than debt service. It isn't an option.

In addition, many local municipalities have their tax rates determined by their budget, not the other way around. In other words, property tax rates are not voted on by the local government, but in fact a plug for whatever rate makes the budget balance, debt service included.

So I think what you are going to see in 99% of situations is cuts in governmental services (sometimes severe) but not cuts in what's owed to bond holders. There will be exceptions, probably far more exceptions than in years past. The history of municipal bond defaults is extremely light, and we could well wind up with more defaults over the next 24 months than we had over the previous 24 years. It won't be a disaster, but it will be pretty bad.

BULLISH: Foreign participation in the Treasury market.

I recently made a case that I thought the dollar would keep declining. What I didn't say is that I thought there would be a dollar crisis, precipitated by our ballooning debt.

First let's look at current foreign participation. The following chart shows TIC data for Treasuries (net purchases) month-by-month (in blue) and 12-month rolling averages (red).

Can't see any crisis here. The rolling average is basically in the same range its been since 2004.

Could a crisis develop? Sure, but I don't understand how the U.S. gets into a currency crisis and there is some other currency that is A) large enough to take the huge net flow the U.S. currently absorbs and B) not impacted by the U.S. crisis.

In other words, let's look back at CDS trading among sovereigns. Here are the levels on 12/31/2007, according to Bloomberg (all in bps, higher means more risk).

• Japan: 8.5
• U.K.: 8.9
• Germany: 6.9
• France: 9.7
• U.S.: 8.4

And at the end of 2008 (note this wasn't the peak, but it was an easy single point to compare all of them)

• Japan: 44.2
• U.K.: 106.9
• Germany: 45.9
• France: 54.1
• U.S.: 67.4

What does this tell us? Confidence in the U.S. declined substantially during 2008, but it also declined in all our largest "competitors" for foreign flows. If things really are that bad here in the U.S., things are probably pretty bad elsewhere as well.

We're also probably past the peak for Treasury borrowing. Not in terms of absolute debt but in terms of the need to sell new securities. Hopefully there will be no "second stimulus," and the TARP funding won't need to be increased. But assuming both those things, I think the marginal supply of Treasury bonds should be declining, thus reducing the fear of a simple supply overwhelming demand.

Over time, I'm sure emerging nations would love to create a new reserve currency. But as things stand, there is no way a new currency wouldn't have a U.S. dollar component. There was talk of Brazil, China and Russia using more SDR's from the IMF in place of dollar assets. But such a move strikes me as entirely political, meant to look like a move toward independence in the eyes of each country's populace. In reality SDR's derive their value from... Ewok tom-tom roll... the U.S. dollar, pound sterling, euro and yen!

I think the reality is that the U.S. is going to have to raise taxes to pay down our debt. I think there will be significant political pressure here to do something about the deficit, as I think Americans don't like the idea of ballooning debt. Healthcare reform may or may not happen, but either way, its going to just mean more or less of a tax hike. That's going to create significant problems in terms of consumer spending, but would improve the whole foreign Treasury participation problem.

Muni Insurance: A passenger on our last voyage

MBIA is down $1, which is about 20% on a downgrade by J.P. Morgan. This after surging to almost $7 in recent days on reports that the company might be able to foist some of their MBS exposure back to the originating banks.


The interesting question to me (since I wouldn't actually touch MBIA's stock with a 10-foot Gaffi Stick) is whether there is any possible business left for MBIA even if the optimistic view of their legal battles comes to fruition. As we all know, MBIA is attempting to separate their muni and structured finance businesses in an attempt to someday write new muni insurance contracts. But is that still a viable business?


Before we answer that, we need to look back at what muni insurance was all about. There is a myth out there that muni insurance was used primarily by weaker credits as a means of lowering their interest expense. That's not really true. I did some digging through old MBIA investor presentations (funny to hear them boast about "penetration" into the structured finance business) and found this chart from 2006:





There's nothing magic about 2006, I just wanted a period which was clearly before structured finance risk started becoming a problem to show what muni underwriting was like during the "good times." We see 28% of the total par outstanding was in GO munis. I did some rough calculations and it comes out to something like 44% of muni underwriting was in GO's. Notice also what you see very little of: healthcare, housing, industrial development (zero). In other words, the riskier segments of the muni market are clearly under-represented.


The point is to say that muni insurance was not typically used as a true credit enhancement, at least not in terms of avoiding default. By now you've heard the stellar record of GO bonds, which almost never default. So who needs the insurance?


I argue that the need for muni insurance is borne more out of information asymmetry than actual credit enhancement. By this I mean, investors in municipal bonds often struggle to get complete and up-to-date information about a given municipality. Take for example a random school district in Pennsylvania: Glendale School District. Go to their website and try to find their financials. I couldn't find them. So if you had bonds for the Glendale School District, how would you follow their financial performance? You could potentially get someone from the Superintendent's office to send you reports, but odds are they would only be produced annually and with a long delay before the report is available.


Imagine if a corporation wanted to sell bonds, but refused to report regular reports. Would the bond be sellable?


Muni insurance filled this gap. The insurer could demand certain information and/or legal language in the bond deal that investors could not. Especially not individual investors. In that way, muni insurance was a little like title insurance on a home. No one expects to use it, it very rarely comes into play, but in the event that something truly crazy happens, like the Orange County scandal, investors are covered. The insurer deals with it.


So I'd say that municipal bond insurance served a certain public purpose. Allowing local municipalities to sell bonds at attractive rates.


And yet, I still think muni insurance is a dying business. Why? Because in a way, MBIA/FGIC/XLCA/Ambac's problems are very similar to Fannie Mae and Freddie Mac's. The for-profit nature of the firm got in the way of realizing the public purpose. Now obviously MBIA was never a "public" entity in the way Fannie/Freddie were, but I think the point stands. Investors aren't going to trust insurance the way they used to ever again.


Still, the need for resolving this information availability problem remains. I ultimately think the better solution is for states to form their own credit enhancement programs. This could be accomplished through a bond bank, which is common in Indiana and California. It would have to be altered from some of the existing bond bank programs, where the underlying credit was only whatever municipalities participated in the specific issue. In the old days, a California Communities bond issue might only be backed by 2 or 3 local California towns, but would also carry Ambac insurance. That used to be fine, but now its obviously not going to work. California could alter their bond bank program such that a surplus account is created to make up any losses on individual loans, which would allow for a better overall rating on their program.


Another possibility is some sort of state intercept program. This would be where the state agrees to backstop local municipal school district deals. There are such programs in force in Texas, for example. The problem here is that such programs are usually only available for school district bonds, not for other local government needs. So if Pflugerville School District needs a new roof on the high school, that can be done through the Texas Public School Fund. But if the town of Pflugerville needs a new roof on City Hall, there is no state help.


I would like to see these kinds of programs expanded without the help of the Federal government. One of the problems that always worries me about municipal finance, and its lack of transparency, is that good fiscal management can't always been differentiated from budgetary shell games, especially on the local level. Again, this is an area where the muni insurers were a benefit since they could enforce certain standards better than individual investors could. I could see a state-level insurance pool filling this role, making sure local issuers keep to some standard of good fiscal management. But if it rises all the way up to the Federal level, there will be too much distance between the issuer and the guarantor.

California's Budget: Unfortunate that I know the truth?

By my estimation, California actually closed about $15 billion of its $26 billion deficit. Maybe less. Its looks like technically they'll be able to go into the next fiscal year and resume paying their bills (assuming the legislature passes the budget bills), but its obvious this budget involves a lot of pushing the problem into future years. Consider the following:

• According to the LA Times, the budget includes $1 billion from sale of the State Compensation Insurance Fund, but that no one thinks such a sale can be accomplished this year.
• It takes $1.7 billion from local redevelopment districts, a move that was ruled unconstitutional just last year. According to one district official I talked to, there is nothing materially different about this year's proposal to suggest it wouldn't be struck down again.
• The budget also borrows $1.9 billion from local governments. This would need to be paid back.
• Another $1.2 billion will be saved by pushing payroll back one day, from June 30 to July 1. Effectively pushing $1.2 billion onto the next year's budget. But its still money out the door.

So right there, we've identified about $6 billion that isn't any kind of long-term solution. Basically I'd argue that California will start next year $6 billion in the hole.

Now ask yourself, will revenues increase?

The answer, even for someone pretty optimistic about economic growth, is clearly no. Consider the three main sources of revenue for California governments: sales taxes, income taxes, and property taxes.

The first thing to realize is that California's tax collections occur over the course of a year. So the money the state has collected for the June 2008-June 2009 fiscal year occurred during a period when the economy was declining. But what that means is that taxes collected in the early months of that period were stronger than those in the later months. For example, here is Advanced Retail Sales (nationwide) for the June '08 to June '09 period.

I drew a red line over the average for the 12-months. One might simplistically say that sales tax collection for the most recent fiscal year was based on this "average" sales level. But will the average from June 2009 to June 2010 be as high? probably not, even if the economy starts to recover. The current reading ($342 billion) is 2.7% below the average level of $352 billion. Of course, in order for the average to rise to $352 billion, the ending number will have to be double that increase, or +5.4%!

Coming out of the 2001 recession, we didn't get a year-over-year increase that strong until 2003, or about 2 years after the recession was over. Even if the recession ends today, its unlikely sales tax collections will even match last year's figures.

Income tax has a similar problem. If we assume income tax is in large part a function of unemployment, then unemployment will have to average 9.3% just to match 2008-2009's revenue figures.

Is California unemployment going to fall from 11.6% to 7% next year? Extremely unlikely. Unemployment is classically a laggard. We are more likely to see unemployment rise from here, even if the recession is almost over.

Property taxes? Same problem. In fact, maybe even worse. Assessments aren't made in real time. Unlike sales tax, for example which evolved over the course of the year, the task of re-assessing properties to reflect the current environment is an on-going thing. And obviously every new assessment is going to be lower than the previous. I've argued before than home prices are going to keep falling, at least statistically, even after the housing market has bottomed. In this piece, I argued that once transactions pick up, it will only prove that prices are in fact lower, thus making the statistical measure of home prices fall all the more. Even though I believe that transactions will show the real bottom of housing, the point is that prices keep falling for some period thereafter. As an aside, I'd think that's all the more true for commercial property, which trades even less frequently than residential property.

So if I claim that California starts out $6 billion in the hole (probably more) because of accounting scum and villainy, that isn't taking into account the near certainty that revenue will fall during the 2009-2010 period. On top of that, I'm assuming revenue will fall even if the recession is over right now. If it isn't over yet... well... I fear the worst.

Municipal Credit: They never even asked me any questions

California's budget woes are getting all the attention, but as reader In Debt We Trust pointed out, Philadelphia is also halting payments to vendors. In fact, because the current recession is hitting property taxes so directly (which is most local governments' best revenue source), I'd expect municipalities to struggle mightily with their budgets for the next couple years.

Now I expect very few actual defaults among municipal governments. But there will be some. And there will be even more close calls. Situations where municipal governments do things that they wouldn't normally contemplate.

Things brings us to some interesting legal questions that might shake the foundation upon which much of the muni market is based. Consider the use of lease-backed transactions. Here is a sample of language from a municipal official statement. Its for a lease by the City of Tulsa for a city government administration building. For full disclosure, I don't currently own this issue, but once did:

"Notwithstanding anything to the contrary contained in the Lease, if the City does not appropriate funds paid to the Authority pursuant to the Lease for any fiscal year... during the term of the Lease, the City shall not be obliged to make payments for such non-appropriated fiscal year. In such event, the Lease shall automatically terminate and become null and void as of the end of the preceding fiscal year."

So you ask yourself, who the hell would buy such a security? Basically Tulsa can get out of this lease by... not paying it! Imagine if an apartment lease was written this way: "The Tenant owes the Owner the rent, except if he doesn't pay the rent."

The answer is, of course, because if the City doesn't pay its rent, then in theory, bondholders can evict them from the administrative building. Obviously the city would still have to fill an administrative function, and if they reneged on one lease, they'd have a hard time getting another one. On top of that, depending on the situation, bond holders may not have the right to foreclose on the building.

Classically, munis guys have considered the essential service nature of any lease back transaction. So for example, this Tulsa deal, bond buyers can take some comfort that the City has a strong incentive to honor their obligation. In fact, in a typical lease-back deal, the ratings agencies will rate the lease 1 notch below the issuer's general obligation rating. So the City of Tulsa is rating Aa2/AA, this deal would be rated Aa3/AA-.

Now let's look at a different deal, this one for a new toll road being built in the Research Triangle area of North Carolina. This one was just sold last week.

"In July 2008, the General Assembly of North Carolina enacted legislation that included a provision creating a continuing annual appropriation to the Authority of $25,000,000 for the Triangle Expressway System to service debt and fund required reserves in connection with bonds issued to finance the Triangle Expressway System... The legislation states that it is the intention of the General Assembly that the enactment of the annual appropriation ... shall not in any manner constitute a pledge of the faith and credit and taxing power of the State of North Carolina, and nothing contained therein shall prohibit the General Assembly from amending the appropriations to decrease or eliminate the amount annually appropriated to the Authority." (Emphasis is in the original.)

So the state is giving you what? Literally just promise. Bond holders do not have a mortgage on the toll road (which isn't even constructed yet). The beneficial rights to that road (tolls) are 100% the State's. Bond holders cannot get to those funds. So in theory, the State could build the road, start collecting tolls, and then repeal the legislation allowing for payment to bond holders!

Now, I don't think this is very likely, since as I said, if the state reneged on its appropriations pledge, then it would be effectively shut out of the capital markets. But its amazing to think that bond holders actually bought up this Triangle Expressway deal without even demanding the proceeds from eventual toll revenue. At least that would give the state some real economic incentive to keep bond holders whole. Needless to say, I passed on these bonds.

But it brings up an array of legal questions, many of which have rarely been tested in court, if ever. For example, as I said before, bond investors have always valued more "essential service" leases over those designed for economic development. But could a municipality legally choose which lease payments to make? For example, (and I'm just making this up) say Tulsa has this lease for an important admin building, but it also built a conference center which it leased back to itself. Maybe the conference center can't get anything other that some dorky Star Wars convention every year and the City's budget is strained enough. They just want to close the place and walk away.

In a normal corporate setting, a corporation can't just choose not to pay subordinate bond holders in favor of senior holders outside of bankruptcy. Sometimes they can defer payments, depending on how the deal was structured, but even there, the obligation doesn't erase.

As I said above, ratings agencies treat these lease deals very much like a subordinate general obligation. But is it really? Getting back to my Tulsa example, if both leases were structured as subordinate GO bonds, then Tulsa would have to treat both the same. They couldn't choose to walk away from the money losing convention center but keep current on the admin building. The only way to restructure their indebtedness, without bond holder approval, would be in bankruptcy court.

But the leases aren't really subordinate GOs, not in a legal sense. But could someone go to court and argue that all Tulsa's leases are pari passu? I don't know that its been tested, and it probably depends very much on how exactly the indenture language is written as well as each state's constitution.

And what about something like the North Carolina highway, where its just a straight state appropriation. Say the state can't afford to make the appropriation in 2016, but the highway is still in use. Then let's say their fiscal situation improves in 2017. Would the state still be obligated to make its appropriation pledge? If they completely walked away, could a court rule that the State can no longer use the road? Again, I don't think this kind of thing has been tested all that much.

And it probably won't be tested with state-wide revenue issues. North Carolina's reputation is worth a lot to them in terms of lower cost of funds. So it would take a pretty bad situation for them to trash their credit rating. But I'm betting there are some local governments who try some aggressive maneuvering to improve their budget situation. And there will be lawsuits. Oh yes, there will be lawsuits.

California Munis: What is it? Some kind of local trouble?

Lots of people have asked my take on California. Speaking strictly from a bond holder perspective, there are two issues. First, what are the possibilities for missed or delayed payments? Second, apart from actual missed payments, what could cause spreads to tighten or widen?

In terms of California bond holders actually missing a payment, those odds are remote. S&P points out in their report coinciding with putting CA on negative watch:

An austere analysis of the state's ultimate capacity, from a budgetary perspective, to service its debt suggests to us that at $35.97 billion, constitutionally required spending on education (Proposition 98 expenditures) for 2010 leaves $53.15 billion in resources available for debt service (estimated at $5.74 billion) on general obligation and lease revenue bonds.

So if it came down the state actually running out of cash, first certain education spending would be met, then bond holders. On that basis, there is plenty of coverage. I think this leaves the likelihood of a payment completely missed as extremely low.

Now a payment delayed is a different matter. If the legislature were to not pass a budget by June 30, the state wouldn't be able to sell short-term notes to restock their checking account. At that point, I really don't know what the protocol would be. If, in theory, the state literally ran out of money, they obviously couldn't forward coupon payments on to bond holders. This would be a form of default. But of course, bond holders would eventually get their payments, most likely when the next quarterly payments were made by tax payers.

We have to imagine what such a world would look like. You think Californians are pissed off now? Imagine the state is literally unable to make payroll. The political backlash would be severe. The fact that bond holders get cash first would put tremendous pressure on legislators, not the least of which would come from powerful public employees unions. So I imagine the most likely scenario is that some kind of budget is passed in the next few days.

Unfortunately, the odds also seem high that the budget will include some one-time revenue measures to help close the gap. As S&P noted, that's a problem, since it will likely mean the state will be in the same budget situation next year. Revenue items like sales tax might improve next year, but even in an optimistic economic scenario, unemployment will still be very high and property tax revenues will likely fall again. Its very hard to imagine how California's revenue would experience organic growth in 2010 or 2011.

If the budget is passed with significant stop-gap measures both the ratings agencies and bond holders will react negatively. I'd wager that right now players in CA GOs are unusually tilted toward speculators, hoping for a pop. A budget which doesn't address long-term problems will fail to create a pop, and most likely cause speculative players to sell.

What the legislature should do is create some mechanism for funding a reserve fund, even if the reserve won't be funded this year. For example, some kind of provision by which revenue flows into the reserve if revenue grows naturally by some percentage.

Ideally, there would also be work done on reforming CA's budget process. The combination of referendum-based spending with no attached revenue source is just silly. The corresponding need for super majorities to pass tax increases is similarly dumb. Its an obvious recipe for runaway spending without any reasonable means of funding the expenditures. A start would be to require all spending referendums to either have an explicit revenue tied to them, or to result in an automatic increase in sales tax. That would make voters think twice about voting an increase in stem cell research funding.

There is substantially more risk in local California credits, especially smaller school districts. One of the one-time measures the legislature is likely to use is borrowing/curtailing local aid. Combined with the fact that school districts take most of their funding from (gulp) property taxes... I think we're in trouble.

Municipals and Chrysler: What happens to one will affect the other

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"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 belttightening, 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."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt...

Build America!

You may be asking yourself, what the hell are these BABS every one is talking about? Is Barbara Streisand trying to pull a redux of the old Bowie Bonds? No! Its even stranger than that!

As you know, municipal debt is usually tax exempt (not always, as is commonly misunderstood). Thus the IRS collects nothing on whatever interest income individuals realize out of municipal bonds. Since its mostly the wealthy who buy munis, that's about 35% in taxes not collected.

But here is the problem, individuals can only buy so many bonds. For most of the last 10 years or so, any excess supply from municipalities was soaked up by TOBs. Now those programs are all but extinct, and individuals can't take up the slack.

The Federal government has put forth "Build America Bonds" (BABs) as an alternative. See, while individuals aren't buying enough bonds, pension funds, money managers, and even sovereign wealth funds are dying for long-term bonds that let them sleep at night. Currently there isn't much in the corporate bond world that fits that bill. State and local governments are much safer. As I've written before, a municipal default has very little in common with a corporate default, so even if we assume that municipalities will suffer through more stress than any time since the Depression, its still a relatively safe market.

The Treasury gives the municipality a 35% rebate on the interest cost of a BAB. So if the municipality issues bonds at 6% with, the Treasury will rebate the municipality 2.1%. This allows non-tax paying institutions to buy the municipal debt with taxable-type yields.

Buying in BABs has been extremely aggressive. We saw the New Jersey Turnpike issue bonds maturing in 2040. They were issued at $100 on 4/20, traded as high as $106 that same day! Of course, California's huge $6.8 billion deal stole the thunder. I myself tried to buy $6 million and got zero. Meaning the bond was in such hot demand, they didn't give me a single bond. Either that or its J.P. Morgan (who underwrote the deal) giving me a giant middle finger. Right back at you Dimon...

Anyway, these bonds aren't for you. Don't buy them in the secondary. Its fine if you are a pension fund or some other entity with long-dated liabilities. In fact, I think these bonds are perfect in those circumstances. But for every one else, stick with more liquid intermediate-term securities. I've been trading taxable municipal bonds my entire career, and trust me when I say the liquidity isn't there. So these bonds have to be mostly buy and hold bonds. Which is fine, but do you want to be buy and hold for the next 30 years?

By the way, the reason why BABs are currently only long-term bonds is because that's where the municipal yield curve is widest vs. the Treasury curve. In shorter bonds (say inside of 20-years) a classic municipal bond issue makes more sense for the issuer.

Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County.

Municipals Bond Defaults: Oh, switch off!

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

Company B:

• 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

Company A is J.P. Morgan. Company B is the State of California.

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.)

Bad liquidity cuts both ways in municipals

Municipal bonds have posed an impressive rally in the last few days: the Barclays Municipal Index is up 3.78% since 12/15. That is better than either the Treasury market (+1.55%) or the S&P 500 (+0.57%) over the same period. As much as I think munis are a great value here, this rally has more to do with illiquidity than anything else, and it is a stark lesson for anyone looking to trade fixed income over the next year.

First, consider why municipals have performed so poorly recently. The Municipal Index had fallen over 9% from September 11 through December 15 before rallying this past week. During the same period, the Treasury market rose over 7%. Its easy to point to credit worries about municipal issuers, after all, state budget woes are a constant headline. But this can't explain poor muni performance in its entirety, after all, even munis backed directly by Treasury bonds in escrow haven't been immune from the sell-off.

A better explanation is that many of the biggest holders of munis have become forced to raise cash in recent months, particularly mutual funds and insurance companies. In the old days, the broker-dealer community would have bought up these bonds, held them on the balance sheet, and eventually sell the bonds to another customer for a profit. In essence, dealers used to serve a sort of wholesaler function, holding bonds in inventory while looking for an end-buyer.

Today, dealers are no longer willing to hold bonds on balance sheet. This means that if customers want to sell municipal bonds an end buyer must be found first. If the seller needs immediate liquidity, s/he is at the mercy of whatever end-buyer happens to have available capital at any given moment. Not surprisingly, this results in lower prices on bonds.

But that same illiquidity cuts both ways.

Recently, buyers have emerged in the municipal market, spurred in part by the Fed's aggressive rate stance as well as a desire to add duration before year-end. But whatever the reason, buyers are finding that dealers have no bonds to sell. Buyers want to buy at "forced sale" prices, but are finding a dearth of forced sellers.

Now those that want to buy are having to pay prices high enough to entice current municipal bond holders to sell, thus pushing the trading price of municipal bonds dramatically higher in a short period of time.

You can imagine brokerage firms having once acted like a buffer between buyers and sellers. They were willing to buy when the market wanted to sell, and then sell when the market wanted to buy. Now they are acting like true brokers, matching buyers and sellers, but not putting the firm's capital at risk either way.

What does this bode for municipals going forward? Difficult to say. Munis offer very strong long-term value, but the technical picture is cloudy. But this whipsaw trading should serve as a warning to anyone involved in the fixed income markets. The lack of market making activity isn't unique to municipal bonds. The situation is similar in almost all bond types other than Treasuries and large issue government Agencies. And we should expect the same kind of whippy price action in other sectors as well.

It thus represents both an opportunity and a danger. If you are willing to buy when others are selling, you can buy good bonds cheap. This is true in various sectors, from hybrid-ARM MBS, to municipals, to commercial MBS, to corporate bonds.

But one also needs to be careful assuming that fixed-income sectors are moving for fundamental reasons. Right now, to assume that the current muni rally is some sort of all-clear sign is a mistake. The muni market didn't suddenly forget all of the problems facing municipal bonds, both fundamental and technical. Rather certain buyers came into the market, found the primary calendar empty and secondary supply sparse. The result? Higher prices. There really isn't anything more to it.

Port Authority: You overconfidence is your weakness

The headline is that the Port Authority of New York/New Jersey got no bids on a $300 million municipal bond offering. Its distressing, yes. Its a clear sign of how dislocated the muni market is, yes. But the mainstream media is badly missing the most important aspect of this story. This was a problem entirely of the Port Authority's creation.

Alright, raise your hand if you've heard that liquidity is bad. Oh and raise your hand if you've heard that broker/dealers are capital constrained. Also raise your hand if you've heard that the municipal market is dislocated. Is that everyone? Every person who reads Accrued Interest is well aware of the problems in this market, I'm sure. Keep that in mind as you read the following.

The Port Authority was attempting to sell taxable municipal bonds, which is to the municipal market what the Gungans were to the Naboo. Taxable municipals, while potentially great investments, don't have the natural buyers that tax-exempts (e.g., mutual funds) that tax-exempt bonds do. Taxable munis should trade like high-quality corporate bonds, but tend to be much less liquid, even in good times. $300 million is a lot for any municipal deal, but its a humongous size for a taxable municipal deal.

Next, the Authority tried to do this sale competitively. Basically there are two ways municipalities come to market. One is a negotiated deal, where the issuer hires an investment bank ahead of time. The bank agrees to buy the debt from the issuer and resell it to the public. In a competitive deal, investment banks are invited to bid on the issue. The highest bidder then buys the bonds from the issuer and resells them to the public.

In a negotiated deal, the investment bank has time to work the bonds. The salesforce knows its their deal to sell, so they are more motivated to sell it. In a competitive deal, the salesforce usually only has a hour or two, and if their firm's bid isn't the winning bid, the salesforce has wasted their time. In addition, a competitive deal requires the winning investment bank to immediately and unconditionally buy the deal from the issuer. In other words, commit capital.

So when a competitive deal comes along, what's Wall Street going to do? They are completely unwilling to commit capital to something as low-margin as municipal bonds. So they are going to only bid if they have the deal pre-sold. This has been the case for several months, but has never been more true than right now.

Now if you and I know all this, then surely a big municipal authority like the Port Authority must know all this. And even if they don't, then clearly their financial advisor must know all this, after all, that's what the FA gets paid for. And yet, knowing all of the above, they decide to go forward with a $300 million competitive deal. They decide that Wall Street should cow to their every bond issuing whim. Perhaps they figure that Wall Street takes the PATH trains into Manhattan in the morning, they must be dying to buy Port Authority bonds!

The fact is that the investment community isn't dying to buy anything! Even the TGLP bonds are being sold over a period of multiple days. And those are 100% full faith and credit! The Port Authority apparently scoffed at this fact. Surely investors would scarf up their bonds in mere hours! Right?

I know at least two large Wall Street firms had over $100 million in orders, but couldn't get to the $300 million number before the bids were due. So guess what? They didn't bid. It wasn't that there was anything wrong with the Authority's credit. It was that the Authority decided to pursue a perfectly stupid means of raising cash.

Why did the Authority need $300 million right now? If they had done a $75 million competitive deal, they would have had no problems. They could have done another in 3-4 months. And another a couple months after that. Or they could have done the deal negotiated. Given their bankers time to convince the big whales that 3-year Port Authority bonds at +375 was a great deal. I'm telling you, it would have worked.

But instead, the Authority assumed they were endowed by their maker with the right to foist bonds onto Wall Street. Instead of paying attention to market conditions, the Authority pretended like it was business as usual. Instead of following a sensible strategy for raising cash in a liquidity-challenged environment, the Authority displayed a foolhardy level of arrogance.

And what did they get in return? A lot of egg on their face.

Managing California's cash ain't like dusting crops

On October 3, California Governor Arnold Schwarzenegger warned that his state might need a Federal loan of $7 billion. This week we find out if that scenario has been averted as California is marketing $4-5 billion in "Revenue Anticipation Notes" or RANs. These will be tax-exempt securities. A RAN is used by municipalities to manage cash flows while waiting for tax and other revenue to be collected.

Originally the deal was to be $4 billion, with $1 billion maturing in May and the other $3 billion in June 2009. Retail orders were taken Wednesday, with dealers getting $3.8 billion in orders. The deal has been increased to $5 billion, with dealers taking institutional orders Thursday.

The yield on the bonds is not yet set. The original sales literature indicated a range between 4 and 4.75%. But with orders coming in so strong from retail, the May maturity will probably yield 3.75% and June piece 4.25%.

At 4.25%, the rate on the California bonds would be about equal to 6-month LIBOR on an absolute basis, and is similar to current reset levels on 7-day variable rate municipals. The 4.25% is also about 6.5% on a taxable equivalent basis, more like 7% if you are a California resident. Any way you slice it, its a lot of yield.

The challenge in placing these notes is the combination of California's economy and the sheer size of the note. A note of this kind would normally be attractive for money market funds and other short-term buyers, especially at that rate. But currently money markets are strapped for liquidity themselves, and have been focused on buying bonds with overnight maturities (or put options) to ensure the fund can meet redemptions. So buying a longer-term bond is probably out of the question.

Vulture buyers entering the municipal market are probably looking elsewhere. If you want to buy munis cheap, you should buy longer-term securities, where a recovery will result in a price pop. Currently 15-year munis can be had for at yields over 5.5%. If that rate were to fall to 4.5%, the owner would enjoy a 8-9% price return. With the short-term California bond, investors best return is going to be the yield.

And of course, California is at the epicenter of the housing crunch, which is likely to weigh on property tax revenues for some time. Offsetting this somewhat is the diversity of their economy and the benefits of Proposition 13. Bear in mind also that local governments are the primary beneficiaries of property taxes, whereas the state revenues are primarily sales and income taxes.

So are these California bonds worth the risk? Perhaps California will have more budget difficulties than other states, but ultimately the state's budget will come down to tough political decisions rather than an inability to finance their debts. Put another way, I'd rather own 9-month state of California paper at 6.5% taxable equivalent levels than most corporate bonds. And its investors thinking along those lines that will wind up buying up these bonds.

What is this place?

The stock market is getting crushed today, but that hardly tells the story. The Dow falling 350 points is rare, but its happened many times. What's happening right now in the credit markets is unprecedented.


I'd like to focus on an under-reported corner of the credit markets: municipals. We have a variety of factors converging to cause municipal bonds to perform extremely poorly.


First of all, market makers are hoarding cash. Remember that the Wall Street titans were never dominant municipal players. The better muni shops among big Wall Street firms were the ones with large retail operations, like Merrill Lynch. Regional brokerages were always major players (as a group) because they had the local customers who wanted to buy local bonds. A firm like Morgan Keegan or Stephens knew the market in Mississippi or Arkansas or Tennessee better than anyone from New York.


Regional brokers face a more uncertain funding than larger Wall Street firms, especially if they are not tied to a bank. Typically dealers fund their inventory either through repo or through bank credit lines, with the later probably more common among regionals. The bank credit lines function very much like repo in that there is usually some basket of acceptable collateral and that the line must be over collateralized by some amount.

The reality is that those bank credit lines are usually not contractually committed for an extended period. In other words, the lending bank usually has the right to pull or reduce the line at any time, or at least with relatively short notice.

In that kind of environment, dealer firms cannot hold inventory. If they were to see their credit lines taken away, or even reduced, the firms would see significant odds of sudden bankruptcy. Forced sale of anything right now, even municipals and government agencies, would entail significant losses.

So municipal trading must occur with no market makers whatsoever. Obviously that makes the cost of immediate liquidity much higher.

Add to that the fact that municipal funds, particularly money market funds, are seeing large outflows. Currently tax-exempt money market fund balances are about 10% below August levels. While there have been some inflows the last couple days, there is still tepid demand for money market securities. And investors are not being unreasonable in selling their tax-exempt money market funds. Most muni money market securities rely on bank letters-of-credit for liquidity. And various U.S. regional and European banks are major muni LOC providers. In fact, Wachovia was a very big player in that market. While Wachovia-backed bonds are to be backed by Wells Fargo or Citigroup, certainly there is good reason to be worried about other banks.

Meanwhile other municipal buyers are pulling back as well. While I have not seen stats on long-term muni funds for September yet, anecdotal evidence is that there have been outflows. Plus there is the spectre of closed-end funds deleveraging. Closed-end funds have been using auction-rate securities to create leverage for many years, but have recently been trying to refinance those securities. The current market has made that all but impossible. So there is a good chance that closed-end funds will have to sell a percentage of their current holdings to deleverage.

On top of everything, things aren't exactly rosy for municipal governments. There is no doubt that states and local governments are going to face their most difficult budget periods in a generation, and it might not get much better next year either.

Still, I think intermediate-term munis are a relatively good trade. You've got pre-refunded bonds, which are backed by Treasuries, trading at a higher yield than Treasuries. You've also got hospitals, public universities, transportation authorities, etc., that are less sensitive to housing prices and general economic activity. I think if you focus in that area, and can stomach the lack of liquidity, those will turn out to be good long-term trades.

In terms of muni weekly and daily reset VRDNs, if you are going to play in those, make sure you have a ultra-safe LOC provider. There are bonds out there with Fannie Mae and Freddie Mac LOCs which would seem the strongest. But again, be sure you understand exactly what the LOC means. If you can't understand it, don't buy it.

MCDX: We had better start the evacuation

A few months ago I heralded the MCDX as a potential game changer in the muni market. I'm afraid its failed to live up to its potential, and arbitragers are likely to step in and push it into oblivion.

For those who did not read the original article, the MCDX is credit default swap (CDS) index of 50 municipal credits. By buying (or selling) the index, you are in effect buying (or selling) equal portions of 50 different protection contracts. If one of the credits within the MCDX defaults, the buyer of protection delivers a qualified obligation of the defaulted credit to the seller of protection. In return the seller of protection pays 100% of the face value. The par amount of the bond delivered is equal to 1/50th of the original notional amount.

The current 5-year MCDX spread is 86.25bps. This means that in order to buy $10 million in default protection against the 50 names in the MCDX, investors make the equivalent of $86,250 in annual payments, assuming a new contract were created today.

Historically, defaults on municipal credits have been very rare, particularly in comparison to corporate credits. According to Moody's, there was only 1 default of a "general obligation" (GO) municipal (meaning a state or local government with taxing authority) from 1970 to 2006, and that default was cured in 15 days. Among investment-grade, non-GO municipal bonds, only 0.29% defaulted within 10-years of issuance, according to Moody's. This compares with 2.09% of investment-grade corporate bonds.

However, the weak economy generally, and declining property tax collections specifically, could result in unusual pressure on municipal credits. Yet, the particular credits within the MCDX are among the safest in the market. Property taxes are usually collected by states, but distributed primarily to cities, counties and school districts. While other revenue sources, from income and sales taxes to toll collections are likely to be impacted by the current economy, those revenues are likely to follow a more typical recessionary pattern, which municipalities have weathered in the past. The MCDX includes only 4 cities (New York, Los Angeles, Phoenix, and Columbus, OH), one county (Clark County, NV), and one school district (Los Angeles).

So perhaps municipal default rates will rise in the future. But wouldn't we expect corporate default rates to rise as well? Compare the MCDX with the CDX IG, an index of 125 investment-grade corporate credits. The CDX IG closed on Wednesday at a spread of 144bps.

Using standard recovery assumptions for both indices (80% for munis, 40% for corporates), one can calculate the expected default rate based on each index's current spread. The graph below shows the cumulative expected default rate based on current spreads for both indices.

As you can see, the MCDX is trading at levels that imply nearly 20% of the municipals in the index will default within 5 years. Again, it seems likely that municipal credits will be more stressed than in years past, but given that the credits within the index are only mildly exposed to property taxes, a 20% default rate seems unlikely.

In addition, because of the stronger recovery expected in municipals, the current spread levels imply greater default levels for municipals than investment-grade corporate bonds. This is tough to imagine. We know consumers will be pinched, but given a choice between paying their taxes (and avoiding jail) versus buying goods from corporate America, I think its obvious which way people will go.

So why not sell protection on the MCDX versus a half as large long protection position in the CDX IG? The trade would be slightly positive carry, and your only bet would be that losses among the 50 municipals are less than half of the 125 corporates in the CDX IG. Or if recovery is similar to historic norms, then merely that municipal defaults will be about the same as corporate defaults. Whatever your view of the economy, this should be a relatively easy trade.

I think at some point, arbitragers will put this trade on, and it will expose a lack of deep liquidity in the contract. Talking to various traders, it looks like much of the trading in the MCDX has been macro hedgers, not betting on munis in particular, but using municipals as a means of hedging against a disaster event. But at current levels, the hedge is too expensive, and given a little positive momentum, it will be exposed as such.

Moody's Global Scale: The last remnants of the old ratings have been swept away

Bowing to significant political pressure, Moody's is set to change the way they rate municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different than other bond categories. For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10-years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district, or state) there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has admitted that their municipal ratings aren't comparable to corporate or ABS ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York, and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

However, recent stress in the municipal bond market has brought politics into the discussion. From auction-rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in hears past. Bond insurance and bank letters-of-credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

Politicians, lead by Congressman Barney Frank and California Treasurer Bill Lockyer have been pressing the credit ratings agencies to rate municipal bonds based on expected loss only. A June 12 press release from the California Treasurer's office reflects the argument proffered by the issuers: "Lower ratings [for municipal bonds] have cost taxpayers billions of dollars in higher interest rates and bond insurance premiums." The theory is that there is a direct correlation between the ratings and the interest rate paid by the issuer.

At the same time, Moody's and Standard & Poors are facing serious (and well-founded) claims of conflict of interest relating to CDO ratings. Moody's seems to have made a political calculation: it can't go back and re-rate CDOs, but it can give Barney Frank what he wants with municipals.

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping. (The complete report is available here, requires a free registration.)

That should be a near-term positive, especially for middle-rated credits. There is significantly more demand for A and Aa-rated bonds than for Baa-rated securities, owing largely to legal or policy restrictions. There might not be much immediate effect, particularly until S&P follows Moody's lead. But over time, expect liquidity and the spread for the upgraded bonds to improve. Also, expect S&P to follow suit. S&P faces the same political pressure as Moody's, and now that Moody's has made the move, S&P will be all but forced to acquiesce.

There is a likely negative, however. The high ratings standards for municipals encourages some measure of fiscal conservatism. This is especially true for Aaa-rated credits, where loss of the rating would be politically embarrassing. Of course, municipalities are downgraded all the time, but clearly local politicians would rather maintain their rating than not. If the overwhelming majority of general obligation issuers are going to be rated Aaa anyway, that incentive is greatly reduced. In other words, a state like Georgia (rated Aaa) is currently incented to maintain its austerity. But if they could slide all the way down to California's level (currently A1) and still be rated Aaa, they'll probably do it.