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Trades are going sour and the municipalities are rebelling…

… and market spreads are responding (click to enlarge)


implying default rates that illustrate to what extent the market is dislocated.

Find the one that doesn’t fit
Municipal CDS market spreads (via the MCDX index, click to enlarge) imply a 5y cumulative default probability of 34% versus a historical default rate of 0.02% (Moody’s) - a figure 1500x higher!


Purists in the room will claim that we cannot rely on a rating agency for historical default rates, as statistics come only from rated issues. Additionally, the default numbers do not take into account conduits where the default rate can run 10x higher – in fact, 2008 alone saw over $6bn of muni defaults – 19x higher than the previous year, though this has been in non-GO and unrated issues all of which recovered at 100% (anyone involved in the CDO market would laugh at a “default” that recovered at 100%, having been inured to the trusty old 0%).

The high market implied default rate is also skewed by the high expected (marked) recovery for muni bonds of 80% versus 40% in high grade (a higher recovery implies a higher default rate for a given CDS spread level) as well as potential uncertainty over deliverable obligations into muni CDS.

Each down cycle in markets exposes those unsophisticated investors who are “swimming naked”. Municipalities tend to be perfect examples as the Lack of Sophistication / Assets Under Management quotient is strikingly high. Though the current crisis is presenting muni’s with more than badly gone trades, it is these trades that offer the biggest lessons to investors.

Below I walk through what has gone wrong and what lessons have been learned (or relearned). In particular, I suggest the following guidelines to both the municipalities that have gone off the trading deep end as well as the banks that have assisted in the process.

Suggested Guidelines (fleshed out below)

Investment guidelines for municipalities:

  1. Take no basis risk
  2. Use no leverage
  3. Make no punts

Risk management guidelines for banks:

  1. Do not offer double-down trades
  2. Pay attention to “willingness to pay”
  3. Use credit mitigants like collateral and mark-to-market trigger agreements

Munis under stress
Though Muni spreads are clearly too high, it is equally true that many municipalities are under economic stress. In April, Moody’s assigned a blanket negative outlook to the entire U.S Local Government sector, citing fiscal challenges as a result of the housing market collapse, dislocations in financial markets, and a deep recession.

  • Total fiscal 2009 budget deficits stood at $72bn, or 12% of general fund assets, according to the Center on Budget and Policy Priorities
  • Decline in state revenues is accelerating due to a decline in sales and tax receipts
  • Tight capital markets are constraining raising funds, though issuance has recovered since the Lehman default
  • States are facing challenges with their pension obligations just as falling equity and corporate bond prices have eaten into investment pools

With Jefferson county teetering on the edge of Chapter 9, Vallejo, Calif recently entered Chapter 9 protection. Other California cities, including Rio Vista and Iselton have also said that budget gaps may force them into insolvency.

Outside of the difficult economic environment, munis have also been embroiled in their own financial mess, involving VRDO’s, TOBs as well as the monoline insurance disaster all of which are putting additional pressure on finances. In fact, trading decisions made by municipalities now figure in municipal investor analysis just as strongly as fundamental indicators like unemployment, interest expense and general revenue.

The Brave New World of Muni Trading
Below I list the trades executed by municipalities that have been particularly prominent in the news.

The most interesting trade to come out of the muni crisis has been the debacle seen in the variable rate market. The two types of variable rate muni securities are VRDOs and ARS. They are broadly similar but vary in puttability (VRDO’s are puttable, ARS’s are not), denominations, monoline coverage, investor types etc.

The most important thing, which is common to both types of securities, is that the interest rate resets periodically according to some basic rules (auction-failure for ARS or a result of the remarketing process/changes in specified index for VRDO). The interest rate resets either to whatever rate clears the market or in the case of auction failure, steps up to a very high level so as to compensate those investors who were not able to sell their securities. These securities were very popular with muni issuers simply because, even after all the structuring fees (bank letter-of-credits and monoline insurance), the variable short-term rates paid by issuers were less than if they had issued long-term fixed rate debt.

The rates paid on the VRDO’s have tended to track the front-end cash/Libor levels. For this reason, the municipalities, bowing to the wisdom of risk management, hedged their interest rate exposure by paying fixed on interest rate swaps (or buying interest-rate caps). The floating index on the swaps was typically 67% of Libor. So, in the ideal case, the muni is paying a floating rate while receiving pretty much the same rate on its swap hedge on which it pays fixed.

When the market grew suspicious of monolines, participants rushed to put the bonds back to the market just as the bids retreated from auctions. Clearing rate levels shot up and ARS’s hit their maximum rates – most well-known is the case of Port Authority which started paying 20% vs. an earlier 4%.

So, the net result was that the floating rates the muni’s were paying on their VRDN’s shot up (owing to general illiquidity as well as the concern around monolines), while the floating rates they were receiving on the swaps collapsed (as interest rates fell) – meaning the muni’s managed to lose money both on their bonds as well as the hedges.

In retrospect, the municipalities made a number of key mistakes:

  • Liquidity risk – the most fundamental mistake was similar to the one that befell the Structured Investment Vehicles: the reliance on short-term debt. Once cracks appeared in the monoline wraps and investors withdrew into cash, the muni’s were not able to roll over their debt. The municipalities were effectively subsidizing the rate on their debt by writing a massive liquidity option. They compounded the problem by backstopping their own short-term debt with impossibly high rates, knowing full well that paying such rates on their debt was not sustainable. The realization by the market of lack of demand for variable-rate securities and the unsustainably high rates paid on the debt only added to the lack of confidence in muni debt
  • Monolines – anything having to do with monoline wraps tends to be procyclical meaning it will exaggerate the pain on the wrapped products. The basic point is that the nature of the monoline business suggested that the time when an investor will seek to benefit from the wrap, is exactly time when that wrap will be worthless. Apparently, some municipalities have also agreed to post collateral in the case of ratings downgrades, something which would tend to happen when the monolines are gone, the economy is in recession and cash is at a premium and difficult to raise and swaps are negative-MTM to the muni’s.
  • Rates – municipalities may be forgiven for failing to foresee the silly price action in 30y swap rates which are still trading below 30y treasury yields. This was due to hedging of structured rate notes by dealers issued mostly to individual investors. The massive rally in rates has led banks to receive fixed in size in the long end of the swap curve in a largely illiquid market. This has led to large losses to the swap hedges done by municipalities. Most of these have tended to be in the long end of the curve, just where the rally has been most brutal.

Selling swaptions
Second on the list of poorly-thought-out trades has been the selling of interest rate swaptions. On the face of it, the motivation for selling swaptions looks quite reasonable. The muni issuer sells a payer swaption (on exercise the muni will pay the fixed strike). If the swaption is exercised, the muni pays fixed, receives floating and at the same time issues floating-rate bonds and uses the proceeds to refund the outstanding issue of bonds. Net result is a locked in synthetic rate for the issuer with some savings from the swaption premium.

This all sounds well and good except for the fact that the banks end up dictating if and when the municipalities issue debt. This decision to issue debt is not based on any fundamental funding need, but rather on the performance of a single trade done with the bank.

A cursory look through the news shows that Erie School District, Philadelphia National Airport and Alabama Schools have all sold swaptions. This suggests that if rates were to fall they, and many other counties and districts who have also sold swaptions would need to come to the market and issue debt, leading to potential supply dislocations.

Structured Notes
This round of municipal crises has been (yet?) notably clear of structured note exposure, unlike the Orange County episode. Recall that Robert Citron put a large part of the portfolio into structured notes, particularly, inverse floaters. In fact, the county bought more inverse floaters (in notional terms) than there was equity in the fund. In the end, it was the leverage (about 2.6 at the highs), financed via reverse repos, that largely led to the $2bn of losses for the fund.

The particular danger in inverse floaters has to do with their duration profile. As inverse floaters are floating-rate products (the rate is linked to the level of interest rates), one would be forgiven in thinking they have short duration. In fact, the duration is higher than for a similar-tenor fixed-rate bond and increases as the trade goes against the investor (i.e. it starts behaving more like a zero-coupon bond).

What blew up Citron was the fact that he took on two kinds of leverage (you could say, he tripled-down): 1) the particular investment that he chose to express his views – the inverse floater was already dollar-for-dollar a leveraged investment as the duration of the product increased precisely when it went against Citron and 2) Citron put more money into inverse floaters than there was equity in the fund.

In addition to leverage and unappealing duration risk, the county had credit exposure to the dealers which was less of a concern then but is clearly much more significant now. In fact, given the current experience, real money investors are much more likely to structure trades with SPV’s rather than dealers directly in the future.

FX KIKO trades are the latest in the long series of toxic trades executed by unwitting investors during the latest market cycle. In fact, they have been so popular that they’ve been described in Bloomberg magazine, where they were called “I-kill-you-laters”, rather than “Accumulators” – their traditional pre-crisis name.

Though rumors of potential pain by European municipalities is only beginning, recent victims include corporates like Gruma (GMK) – the world’s leading tortilla manufacturer with $700mm losses on the Mexican peso, Citic - with losses of $2.7bn on the Aussie dollar as well as countless other companies and investment houses. Although they come in different variations, these are essentially carry trades with some additional bells and whistles (or, if you like, smoke and mirrors).

Without going into detail, the basic structure of the trade can be summarized by the following chart (click to enlarge).
Salient points of this trade are the following:

  • If the market goes in the client’s favor, they make a little money and the trade matures in short order
  • If the market goes against the client, the notional amount on the trade increases and the maturity extends.

Exporters who did the trades claimed they were being done for hedging purposes. For example, a Mexican company exporting tortillas to the US market received dollars and needed a product that effectively made them short USD/MXN (ie whereby they sold dollars and bought pesos in the market). It is true that these trades positioned these companies the right way, unfortunately the trades were done in much larger size than the hedging operations required and the timing (knock-out components) plus leverage on the trades (which typically flipped from 1 to 2x the size when it went against the client) had no fundamental bearing on the actual financial flows.

It’s not clear how popular this trade was with municipalities though history of municipal involvement with FX stretches all the way back to 1995 when the State of Wisconsin Investment Board lost $95mm from MXN peso trades. Add to this the fact that municipalities pile in, along with companies and retail investors, into popular trades at the top of the market suggests that should see losses on such trades may be disclosed soon enough.

The classification of the trades described above can be summarized as follows:

  1. Basis Risk – these are trades done for fundamental reasons, like obtaining cheaper funding, but go sour occasionally because they expose the investor to some tail risk. VDRN’s was one such trade that exposed muni’s to tail funding/liquidity risk as described above. The key here is to understand that the only reason muni’s were cheapening their funding was by selling a liquidity option to the market. So long that these tail options are viewed as risk free, municipalities will continue making the same mistakes. In reality, nothing is free in the market, and issuance decisions will be made on a more sound basis in the future if all risks are properly taken into account rather than swept under the rug.
  2. Leverage – these are the typical “investment” trades based on a particular view of the market. The danger lies in the execution of the view (e.g. structured notes), as well as the leverage taken separately by the investors (via reverse repo’s).
  3. Punts – these are trades done for apparently “investment” or “hedging” reasons. What differentiates punts from normal investment trades is the fact that the punt is done in a market where the investor can have no competitive advantage or insight relative to other players in the market. In other words, the answer to Ken Fisher’s question “What do I know that others don’t?” cannot be answered satisfactorily. These trades often figure in FX markets and often executed long after the popular press begins writing about their virtues. The FX KIKO, which is based on the carry trade, is an example of such a trade.

In order for the market to move beyond the news cycle of losses by municipalities and other unsophisticated real money investors, there need to be some fundamental changes. These changes have to come from both sides of the equation: municipality investment mandates and bank risk management policies.

Recent news has made it painfully clear that municipalities need to abstain from certain kinds of risks. These risks include the 3 categories mentioned above because each one has the potential to bury them, if left unchecked. In general, municipalities do not have the resources to run a full-fledged asset management organization, suggesting that their investment mandates need to shrink significantly. Although, generally speaking, the allocation of more power and decision-making ability to the local levels is not a bad thing, what we cannot have is a situation where part-time town board members without strong and dedicated risk management support staff make decisions that put at risk pensions of thousands of other people, while guided by biased investment advisors.

Investment mandates for municipalities need to be made on a state, if not the federal level and there has to exist a framework for escalating problems higher up before they explode. For example, a county finding itself in financial difficulties should not think that the only way out of trouble is to finance its budget by selling a ton of swaptions to the next friendly dealer that comes along.

On the bank side, dealers need to adapt consistent trading and “know-your-client” standards with municipal counterparties. These should not only include a relatively conservative set of products, but also collateral calls so that “punts” and leveraged trades, to the extent they are allowed to happen at all, are unwound/collateralized early and are treated with more care and tracked closely.

The traditional treatment of counterparty risk does not hold for unsophisticated investors like municipalities who can easily claim in court (often with good reason) that they did not understand the risks in the trades they were doing. Clearly, this will happen only when trades go bad adding its own particular wrong-way risk to these trades for banks.

There needs to be greater emphasis placed on the motivation behind client decisions to do certain trades. For example, an interest rate position done for genuine hedging of risk (preferrably without any basis risk) is very different from a short swaption position done to raise cash. The latter is a clear red flag and suggests that the client is essentially doubling down to get out of a financial jam. The risk management function of the banks should ensure that such trades are not done.