Sleepless in MuniLand: Interview With David Kotok

"[A] distinction must be drawn between financial disturbances and systemic or potentially systemic financial shocks. Financial disturbances arise with some frequency and can have their origins in a number of factors ranging from a geopolitical event such as September 11 to a failure of a specific financial or nonfinancial corporation. However, financial disturbances do not exhibit the very rapid contagion effects present in financial shocks…Credit-related problems… are of special concern because - as we have seen on many occasions - financial markets have a remarkable capacity to cope with financial disturbances so long as widespread credit problems are not seen as an imminent threat. Experience also shows that the fact or the fear of large credit losses is often the key variable through which financial disturbances become financial shocks." (The Report of the Counterparty Risk Management Policy Group II)

"Because the ratings of the collateral underlying the securities [financial guaranty insurance companies or FGIs] insure have declined, most FGIs need more capital to maintain their AAA ratings. With the market uncertainty about the ultimate losses in structured securities backed by the residential real estate mortgages, and in light of the dramatic drop in the value of shares of publicly-traded FGIs, the FGIs face a difficult market for new capital. For example, MBIA issued a surplus note on January 16, 2008, at a 14% yield. That is an unusually high interest rate for a company with an AAA rating. A few days later, the notes' secondary market price declined to the point where the implied yield rose to 20%." (February 3, 2008 Letter from Eric Dinalo, New York Insurance Superintendent, to Chairman Paul Kanjorski, House Subcommittee on Capital Markets

Over the past several weeks, the contagion emanating from the collapse of the market for complex structured assets that contain subprime mortgages has shaken the municipal bond market, one of the safest and most stable parts of the US financial system. Other securitized markets, such as the mortgage GSEs like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are under increasing pressure as investors flee what looks and feels increasingly like a slow motion systemic shock, as defined above by the Corrigan Group's 2005 report quoted above.

Failed auctions in the Muni sector started to occur last summer, but the frequency of these busted auctions surged in the past month as doubts increased as to the solvency of the insurers who once exclusively provided added security to municipal bond investors, thus the term "monolines." These doubts caused the State of New York to threaten to break up some or all of these insurers, separating the low risk municipal bond insurance portfolios from other commitments in order to protect market access for thousands of state and local borrowers.

In order to gain some perspective on this situation and the larger implications for the financial markets, The IRA spoke to David Kotok of Cumberland Advisers in Vineland, New Jersey (www.cumber.com). Cumberland is a unique firm in that it both acts for investors as an independent total return bond manager and also advises municipal borrowers and insurers in structuring offerings. This gives David and his colleagues, who've been focused on this stable marketplace for decades, some unique insights.

The IRA: David, thank you for talking to us on a Saturday morning after yet another hectic week. Tell our readers what is going on in the Muni market.

DK: I keep repeating one important phrase: credit enhancement is not credit replacement. For a number of years, lazy, complacent or unskilled investors and their brokers or advisers or whoever was involved, spent their time depending entirely on the rating agencies and perpetuated this myth of the "AAA" municipal bond insurers as being totally safe. They stopped looking at the underlying credit structure of the municipal bond issuer.

The IRA: Unlike you and your colleagues at Cumberland, of course.

DK: No, at my firm we never stopped looking at the issuer. The credit support for municipal bonds starts with the issuer - which can be perfectly acceptable because it is your local government or the sewage authority or the airport. There are thousands of different infrastructure type issuers in addition to those that have the power to tax or even confiscate property to repay the bond holder.

The IRA: And generally the probability of default is very low?

DK: A single "A" rated municipal bond has about the same default characteristics as a corporate bond rated "AAA" by Standard & Poor's. What the bond insurers did was take a nearly free lunch and bank the insurance premiums for insuring something that was unlikely to ever have a default and thereby require an insurance payment. When a bond was called, the full fee for 30 years of coverage accelerated.

The IRA: Exactly. Could it not be argued that the directors of the monoline insurers were complete idiots for branching out from the municipal bond business?

DK: They seemed to have added idiocy when they got out of the shoe department and got into shirts and they didn't know anything about shirts. And that's a good metaphor. They were doing well with shoes. More importantly, though, is the structural changes in the municipal bond buyers market, which has become dominated by retail and usually older investors. The older investor was willing to accept a lower interest rate for the psychological safety of an AMBAC (NYSE:ABK) or FGIC or MBIA (NYSE:MBI) rating. The broker could sell the bond in 30 seconds. Bonds were viewed as a safe, homogenous insured asset class.

The IRA: But that was precisely the point. Weren't the markets simply replicating the GSE model with private insurance?

DK: Yes in MuniWorld. But no one distinguished among the bond insurers. We did. We examine each bond insurer and we will differentiate between similar yielding bonds because of the internal structures of the insurance. Who paid for this? The bond buyer paid. The bond buyer was willing to accept a lower rate, knowingly or unwittingly. The issuer, therefore, could afford to pay a premium for next to nothing so that the issuer could sell at a lower net interest cost.

The IRA: Until a couple of weeks ago, this was a great arrangement for the dealers and the insurers. Your firm's dual role as a bond fund manager and an adviser gives you a deep understanding of this market. What did the markets miss here?

DK: We know how to read and write a prospectus. If you take apart a municipal bond offering, it is a loan agreement that has between 20 and, perhaps, up to 100 options within it. And the market does not know how, does not do the work, does not spend any effort in valuing those options. This is a good thing for us because focusing on the details is one of the ways Cumberland adds value in our business model.

The IRA: There is no data available for these securities, especially the auction rate and floating structures. None of the major vendors seem to have very detailed data on these securities and the only folks who do have data seem to be the Muni dealers.

DK: There's not much. And yet the fact is that the municipality has to make a detailed annual disclosure regarding its financial status. Very few people know how to read a municipal financial statement.

The IRA: But doesn't it seem odd that the quants on Wall Street have not taken a look at this rich optionality you describe and modeled it to the enth degree?

DK: No, there's a reason. Most municipal bond decisions, investor decisions, are made by retail. That's because the changes in the tax code have, for all practical purposes, excluded the institutions which have skills. For example, the tax code limited banks to bank qualified bonds, small issues only. So you took the whole bank world out of the business of buying Munis for its own portfolio.

The IRA: So unless you have a highly specialized shop like Cumberland, you won't find too many independent specialists in Munis?

DK: Banks went into other businesses. Insurance companies, depending on their structure, went into other businesses. So who's left? Maybe 25-30 million Americans who are in high enough tax brackets to justify tax free bonds and tax free bonds have no pizzazz. There a very few professionals around acting as independent Muni advisers, so these individual investors are left in the hands of the brokers and mutual fund managers. Now the mutual funds had a field day here because they could package bonds and market a fund, either a closed end fund or open end fund, and say 'we'll put together an entire fund of "AAA" insured bonds, do it all for you, send you a monthly or quarterly check for the interest, and you can sleep at night.'

The IRA: And what did the managers charge for this service?

DK: Munis have a high fee structure because you are essentially peddling to retail. Our clients are wealthy enough to justify a large portfolio, millions of dollars and up. We are paid well to guide our clients through this market and we've been lucky not to get stuck with any toxic paper, Muni or taxable.

The IRA: Well, the toxic paper probably didn't meet your risk/return thresholds. We had a conversation last week with the CRO of one of the largest reinsurers, who laughed at their luck not to own CDOs because the spreads had been too tight vs. their perception of the risk.

DK: Exactly. If you don't understand the risk, don't take it. What we do in our shop is map all of the possible worst case scenarios, map the options in each Muni issue. If at the end of that process you can't get that down so that the risk is very clear, then the message is stay away. There was a period of a couple of years when we lagged the performance of other bond advisers who picked up an extra few basis points by taking this CDO crap. Now they are giving it all back in spades.

Let me go back to the Muni market. The Muni market was supported by the capital of the brokerage firms and the underwriting firms and they could maintain what was this grand fiction of liquidity. But now the commercial banks have had losses, their capital is constrained and the dealers are abandoning their traditional liquidity role. So you go to the larger brokerage firms today and they have virtually no inventory of municipal bonds for their brokers to sell because they don't have the capital. One of the larger money center banks just walked away from all of their adjustable rate option securities because they don't want to commit the capital. We're talking about some of the leading names on Wall Street. So you are getting some remarkable situations like the Port Authority of New York auction failure.

The IRA: Yeah, at 20% we'd like to buy some of that paper.

DK: You betcha! Here's an example of the dealer firms walking away from the auction process for one of the largest issuers in the market. The brokers were the liquidity providers because of their capital. Without the dealers, the auction "clears" on an interest rate spike to 20%. That means that the Port Authority has to pay 20% annualized to borrow money for a week. I suspect that it is a little more credit worthy than that.

The IRA: Now some issuers, like the State of Wisconsin, are moving rapidly to change how they approach the markets given the retreat by the dealers. How does this situation unfold next week?

DK: If you are at the Port of New York, you have to answer to two states. First thing you do is advise your board and notify New York and New Jersey. John Corzine and Elliott Spitzer can't stand by and allow the Port of New York to pay 20% interest to borrow money. So this situation is going to change real fast, probably by the next auction. That rate is going to drop. A legitimate auction rate would be 3% or so. If the next auction does not clear, then the Port of New York will just say the hell with this, buy in the existing paper and issue 30-year straight debt. Don't forget that the Port can bid for its own paper.

The IRA: But not all Muni issuers are the Port of New York.

DK: Correct. Take another failed issue like Raleigh-Durham airport. This is a small floater issue, subject to the AMT, and is insured by XCLA. The insurance isn't worth a damn now. The underlying credit rating is an "A." There is nothing wrong with this credit. It's money good. That issue cleared at 8.25% last reset. In my view, that is a bargain. However, the buyer who is in the AMT can't buy it because of a tax problem, thank you Congress. The underwriter has trouble flipping this issue out so this high yielding reset may take months to cure. That airport issuer is not going to spend forever paying 8% for money, but they could spend four or five months to clear that one. For investors, this now becomes an issue by issue situation of assessing municipal borrowers.

The IRA: David, stand back for a moment and tell us what comes next. How does the dislocation, the systemic break in the Muni market affect other markets?

DK: First let's distinguish between the three types of paper. There are auction rate notes, there are floaters and there are funds which repackage the first two.

The IRA: This story sounds strangely familiar. Is it a Muni CDO?

DK: The Port of New York is an action rate note and the result of a busted auction [when insufficient bids were received for the paper] is the 20% penalty rate. Raleigh-Durham is a floater which resets periodically. Remember that the market is now valuing insurance as zero. But if the insurer's credit rating falls, then most Muni deals have standby credit agreements with commercial banks, but these are different for each issue. The exit provisions vary by issue.

The IRA: So how does an investor assess Muni risk in a floater like Raleigh-Durham?

DK: You need to look at all four of the parties: the issuer, the insurers, the banker and the brokerage firm dealer to understand the risk of each municipal issue. As I've said, the dealers are walking away from the business rather than commit capital. The bank guarantor, which has been collecting a fee for years for doing nothing, is now worried and wants to get out. And the insurers don't count any more. The bank is saying, at the first opportunity we are going give notice and cancel our standby commitment. We may be exposed for 30 days or so but we're going to do it anyway. That's the floater game. Again, the market looked at all of these credit enhancements, but not the issuer credit.

The IRA: This paper was supposed to be a commodity, right?

DK: Exactly. The key here was and still is that if you got a solid "A" credit Muni, you know that by putting your money into these failed auctions at 7% or more, you will get a result that is very attractive. We're doing it. We are in the vulture camp right now and seizing this opportunity.

The IRA: And rightly so. How often do you see anomalies like this?

DK: Things like this are rare, once or twice in a generation. Most of the "kids" now on Wall Street are in uncharted waters given their experience. You need to be an old dog to remember things like this. How many folks remember when AMBAC was a downgrade candidate because of Baldwin United?

The IRA: So what happens to this market?

DK: The issuers will go back to selling more traditional type municipal bonds. They go to insurers like Warren Buffett that will carry a solid "AAA." By the way, I agree with you that MBIA, as well as FSA, will be fine at the end of all of this. The market wrote down the value of the municipal bond business to almost nothing. But they forgot or never knew that there is a massive amount of unearned premium amortizing over the maturities of all of these bonds. Warren Buffett offers a 1.5x premium and is trying to rob the cradle. Ha! Municipal bond insurance is a very sweet business.

The IRA: So it sounds like the Muni market is going to sort itself. What's next? You only mentioned two asset classes.

DK: The sleeper issue is coming in the closed end funds. The deal went something like this: Some of the bigger managers in fixed income packaged say $50 million in insured Munis. They established a variable rate preferred for say a third of that amount at a low interest rate because the yield curve was positively sloped. And they issued the variable rate preferred to institutional investors via brokers and it was a one week reset or a 28-day reset or whatever. And they then took that leverage and they offered a closed end fund to the retail public. And the close end fund went something like this: here's the normal bond at say a 5% yield, insured, in the old commodity days, but because we are leveraging a third of this fund, we can offer the investor 6%. And we'll sell you 6% and sell it retail at $10 per share with minimum orders of 100 shares and we'll put a fat 5 or 6 or 7 points commission in it, and the investor will eat it up because it's cheaper on an after tax basis than buying the bonds directly. And that is a result of the leverage.

The IRA: The story of our times.

DK: Now, once that package is in place it has become a passive instrument. There is no active management, there's custody, administration etc., and there is an ongoing fee going to the sponsor firm for essentially doing nothing but maintenance. If people want to sell, they do so amongst themselves through brokers. What about the preferred? It's resetting and it's been used as a liquidity provision by the broker sponsors. They sell it to clients as a money market type instrument, with fees. This goes on for years.

The IRA: So what's the problem?

DK: There is no insurer, number one, because the market said 'Jeez, we have a claim on a $50 million portfolio to secure the $15 million of senior preferred.' We can trust our wonderful broker at a top broker dealer; they'll take us out at par all of the time. Thank you very much. And in days past the broker would earn a little clearing fee, but alas they have all stopped clearing.

The IRA: Oops!

DK: Now, in the last week, I had one client with a $3 million failure in an auction. He didn't tell me he was in the auction. Asked me for help after the fact. He told me that he wants to liquidate everything and go into US Treasury bills. He tells me that he has a couple of million in a closed end fund backed by Sallie Mae (NYSE:SLM) paper and the sponsor broker dealer won't let him out. We liquidated all of his accounts. Now he's rolling bills at below 2%. Think about it. He was an emotional seller. This is the weight on these markets. He and other panicked sellers are driving the yield on Treasuries down and spreads on everything else are widening out.

The IRA: When you put this into the context of a $3 trillion securitization market where banks cannot sell assets efficiently and have no ALM flexibility, and everybody who had a standby agreement with a bank is calling and the banks have to say no, there could be a terrible selloff in these markets.

DK: Now you have the downward spiral. There's no market, no liquidity provider for these funds. They have to sell them to somebody. The brokerage firm may be long gone. There is no backup bank because it was unnecessary because of the leverage of 2:1 that secured the preferred and there's no insurer. That's the black hole, that third class of closed end funds based upon Munis. What happens to this closed end fund? It may have to adjust price or raise yield in order to clear. When it's down a chunk from net asset value…and that chunk may be 20% or 30% before this is over.

The IRA: Did we just hear you suggest a 30% haircut on closed end Muni funds?

DK: Yes, it could be 30%. Nobody knows. We haven't been here before. If it happens, I will be there with a back loader. I'm going to be able to buy that Muni portfolio in a block at a deep discount -- 30, 40 or 50 cents on the dollar. Extend that single trade system wide. What have you done to all of the holders of all of the closed end funds?

The IRA: You've killed them.

DK: And many of them don't even know it yet. They get their monthly brokerage statement. There is going to have to be a market price put on every closed end fund at the end of February. A brokerage firm is going to have to put a price on these funds. Be assured that the firms are not looking to do it either.

The IRA: So what do you tell your clients?

DK: Here's our approach. If you sell in panic when everyone else is panicked, then you are assured of a very poor price. If you buy in panic, then you need an iron stomach. My standard is, when the thought of buying something makes you sick and you puke, then you know that you are near a bottom and that it is time to buy and double down.

The IRA: So what shoe drops next? The GSEs?

DK: On Friday Freddie went off 50bp. My forecast for GSEs is this: We are on another Monday holiday. This time around the Fed is on call so that we don't have another situation where Governor Mishkin is unreachable on a ski vacation. I expect worldwide markets to hammer GSE paper on Monday when the US is closed. The natural progression now for somebody in Asia or Europe who's holding Fannie or Freddie to say 'Let's get the hell out of here' and reduce our position.

The IRA: Yeah, another fun week. Thanks David

Comments

[Reinko]

Good article, David Kotok definitely knows his ways around but he too misses one little detail that is of a very disturbing nature:

Right now the combined reserves of the US commercial banks are 'officially' 18009 million US$ in the red and when you include the money from the FED money auctions it is 70009 million in the red and declining about 2 billion a day...

Don't believe me?

Go to the Federal Reserve H3 file, here is the link:

www.federalreserve.gov.../

In the 'non borrowed' column you can find the real reserves of the commercial banks. I don't know why media outlets like CNN or Bloomberg do not report on this; I guess this news is 'too big' for the average financial reporter...

[User 137633]

How do you think that affects municipal bonds, Reinko?