Are Munis the Next Shoe to Drop?

Apr. 6.10 | About: PIMCO Intermediate (MUNI)

Rick Bookstaber certainly thinks so. He recently wrote a piece which defines the pressure points for market risk and found the municipal bond market to be a problem in need of a solution. Rick writes:

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

Problems occur when things get leveraged and complex (and thus opaque).

If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.

The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.

A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.

Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.

Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

It’s encouraging to see that Rick’s position at the SEC doesn’t preclude him from talking publicly about risk. His framework for assessing market risk is unique and bears using as a tool in other markets. I agree with his assessment about the muni market, as I have written about this on several occasions. The most notable posts were from November 2009.

They echo many of Rick’s concerns about ratings agencies. But, my basic problem with states and municipalities is the same problem I have with Greece. They are revenue constrained by a fall in taxes and cannot use fiscal policy to stimulate their economies. This means they must make budget cuts, raise prices (college tuition fees) and raise tax rates in order to make ends meet. Remember, they are not sovereigns issuing debt in their own currencies any more than is Greece.

Moreover, as with Greece, they cannot rely on the next level of government for support. There will be no aid forthcoming for states anymore than there will be for Greece (see Europe puts the loaded gun on the table but no bailout for the fig leaf of support Greece is now receiving).

And, again as with Greece, the cracks are starting to show because investors are waking up to the fact that default is a likely outcome in some cases. Below are two recent articles that show both the debt difficulties now and the shell games now ongoing:

This is a slow-moving train wreck. Don’t mistake the relative sense of calm for a lack of distress. The risk assessment that Rick makes demonstrates that contagion will be large, the key factors being the size of the market and the likelihood that risk has not been adequately hedged despite geographic diversification. As the incident in Dubai which triggered the sovereign debt crisis demonstrates, all we need for this muni problem to move front and center is a trigger. What that trigger is has less importance than the pre-conditions in the market when the trigger comes. In my view, it is less a question of ‘if’ we will see a raft of muni defaults and more a question of ‘when.’


The Municipal Market – Rick Bookstaber