Municipal Meltdown and Counterparty Conniptions 10 comments
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“Con”-fident rhetoric that we might nary suffer a quarter of negative GDP is embarrassing to anyone who can add. For 60 years markets have been trained to move in Pavlovian response to credit and the a-historic creation of FRB (Fiat Reserve Bank) currency has them salivating. This time there is no dinner, just a 900 billion decibel bell. Ben Bernanke is whistling through the graveyard and the specter of municipal defaults and Credit Default Swaps are about to make him pucker up even more. Even a growing chorus whistling the FRB theme song, “just add money”, can’t offset the incipient deflationary spiral begun.
Until lately, residential real estate steadily laid golden eggs for banks, insurers and municipalities alike. When the golden eggs started cracking, many thought munis were unfairly involved in the carnage rightly meted out to banks and insurers. Maybe rising municipal yields are accurately reflecting rising risk and not merely their insurer’s subprime dalliances. Although municipal insolvency has been rare, Vallejo’s bankruptcy is but a taste of things to come.
Unlimited taxing power is second only to the Federal Government’s printing press and the lack of failure (usually attributable to mismanagement like Vallejo) was there to prove it; only 32 failures since 1980. Those odds are changing. Consider that the average state recognizes over 30% of their income from ad valorem property taxes. Ever increasing values and boosted sales taxes from “flipping” added mightily to municipal coffers during the recent boom. With sales activity now near a stop and property values steadily declining, the loss of revenue confronts states already suffering from a slowing economy. And it isn’t only about the poster states are Florida, Ohio, Nevada, Michigan and California. It’s estimated that 50% of our states are presently in trouble and diminishing property sales tax receipts are why many will face default.
Already feeling the heat, some states are resorting to piecemeal sale of public property to avoid raising taxes. With consumers facing a-historic debt levels, loss of their home-ATM account though negative equity, soaring (non-CPI) inflation and stagnant real wages, municipalities’ ability to tax ad nauseaum may not be enough - they still have to collect it. But they’ve got insurance.
Triple-A municipal bond insurance emerged in 1971. Since that time, the number of insured issues grew astronomically because it was little more than a perfunctory exercise, like selling sun tan lotion to Eskimos; just in case. The meager 3% coverage in 1980 grew to 60% by 2007 and it greatly resembled mortgage points to lower the cost of capital. Ambak (ABK), FGIC and MBIA (MBI) insure about half of all the tax-exempt bonds outstanding but with them on the cusp of bankruptcy themselves, what happens when their insured municipalities seek Chapter 9 bankruptcy protection?
On the private side of the graveyard, the specter of Credit Default Swaps [CDS] is rising from the fresh plot of Bear Stearns (BSC). CDSs emerged in the ‘90s as an off-balance-sheet way to offset balance-sheet risk. They are essentially an insurance product to indemnify the payment stream against a variety of events from a downgrade in credit status to full default. With a modest beginning of less than a trillion in contracts written in 2000, CDSs doubled every year thereafter. As the smell of blood increased in the first six months of 2007, they grew 75 % to a value that now eclipses the value of United States equities markets! Credit Default Swaps are not regulated and there is a reasonable belief that there may be overlap in the counterparty coverage of the same issue over different trigger events. In other words, the CDS party has been delayed but it promises to be a good one.
The private, Sunday night rummage sale at Bear Stearns effectively kept a lid on the brewing CDS counterparty calamity by federally indemnifying the “top secret” assets and stopping one whopper of a triggering event. It only bought time. Many municipalities have been living on the same borrowed time because of the one-year delay in reassessing property values. When the CDS market starts to try to collect in earnest on the growing triggering events it will be joined by a rising tide of municipal defaults. The fallout from the failing municipalities may encourage Federal Reserve creativity again, this time compelling them to indemnify the municipal bond insurance business.
Failures of this magnitude accelerate the present implosion of credit and process of money evaporating faster than it can be fiated. The impact is masked only because bloated real estate, unlike bloated equities, takes years to reprice. This spiral may well rival the Great D because of the unknown impact from trillions of unregulated CDS’s and the immense leverage. Whereas the margin-created market bubble of the 20’s saw investors putting up at least 10% cash, many recent mortgages put up absolutely nothing. Foreclosures are simply delayed margin calls and the desperate machinations of the Fed and Treasury can only delay the impact while looking effective.
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This article has 10 comments:
SECMAVEN
Agreed on the no investment ideas.
We have limited information to aquire reasonable knowledge and a sensible grasp on this. That's Uneducated, Unprofessional, and Unbusinesslike!! How knowledgable were the people who implemented, supported, and theroetically benfited from this and the related scenarios that will impact all of our lives for years unseen? The derivatives mess in general could have been better understood and likely avoided with substantially better accountability. Opportunity missed.
I am not living my life in fear any longer. We have lunar Rovers on Mars, particle accelerators and 300 million hard-work inventive people. Do your research to fare better then others, that is a lot healthier then fear!
Actually this was a great article. As all assets prices start to fall (commodities are always the last) you will want to have....cash. Cash will be king. It's already buying more house than it did last year. Stocks too for that matter. The lack of it killed Bear Stearns and bankrupted a large municipality. Our banks are trotting all over the globe hat in hand looking for it. Soon it will buy more of everything. Just be patient, 2009 will be the year of the margin call.