Few observations on MCDX and the future of municipal bond market

I will keep it short today, since my attention is currently focused on World Cup and sleeping.

The issue I wish to discuss is MCDX [municipal bond index which tracks the CDS valuation of 50 most liquid municipal bonds; administered and data published by Markit] and municipal bond market in general.

Today Wall Street Journal issued a warning article on municipal bond market:

Investors are ignoring warning signs in the $2.8 trillion municipal-bond market, raising the risk of a reckoning, according to some market specialists.

Numerous municipalities are struggling financially.

A Rhode Island city recently said it faces insolvency. Harrisburg, the capital of Pennsylvania, is considering a municipal-bankruptcy filing. And famed investor Warren Buffett recently warned of a "terrible problem" ahead for municipal bonds.

But municipal-bond prices aren't reflecting much concern. Yields on municipal bonds maturing in 2020 stood at 3.15% Friday, up slightly for the week but down from 3.3% in April. As prices and yields move inversely, this indicates lessening concern among muni investors, even as the cost of insuring against defaults has been rising.

To be sure, just 223 out of more than 40,000 municipal issuers defaulted on their debt payments in the past year, says Matt Fabian, managing director of consulting firm Municipal Market Advisors. That represented about $6.4 billion, or just .002% of outstanding municipal debt, he says.

Still, some market specialists say the gaps between municipal revenue and expenditures are unsustainable.

"The day of reckoning is here," says Jeffrey Schoenfeld, chief investment officer of Brown Brothers Harriman. "But municipal investors continue to act as if there's no default risk in municipal bonds."

It could become more difficult for investors to weed out the dangers. Now, professionals put less credence in credit ratings, after ratings providers failed to spot risks in subprime mortgages during the housing bubble.

The ratings system "tends to rely on history, which is not a good guide," says Michael Aronstein, chief investment officer of Oscar Gruss & Sons Inc., which advises professional investors. "Not everybody is going to default, but investors need to do their own analysis and in-depth research to really understand what they are buying."

In recent public testimony Mr. Buffett said he was worried about how municipalities will pay for retirement and health benefits for public workers and that the federal government may ultimately be compelled to bail out states. His remarks were made during a hearing by the Financial Crisis Inquiry Commission, which is collecting information for Congress on what caused the nation's financial crisis.

Mr. Buffett's Berkshire Hathaway Inc. has trimmed its municipal-bond investments to less than $4 billion as of the first quarter of 2010 from about $4.7 billion at the end of 2008.

"I don't know how I would rate them myself," Mr. Buffett testified. "It's a bet on how the federal government will act over time."

Increasingly, municipalities are showing signs of deep financial stress. Harrisburg said it might file for Chapter 9 bankruptcy proceedings. And Central Falls, R.I., whose motto is "City with a Bright Future," handed control of its finances to a receiver, unable to pay its debt

The news helped to push up prices to insure municipal bonds through credit-default swaps.

Credit-default swaps, which allow even those who don't own bonds to bet a municipality will default, are traded on more than a dozen states and dozens of smaller municipalities.

A basket of 50 of these contracts trade through an index called Markit MCDX. The cost of insuring $1 million of five-year bonds rose 16% in the past week, to $20,000 a year.

The contracts are thinly traded, making their prices vulnerable to big swings. Still, says Michael Gormley, a Markit spokesman, "The widening is indicative of growing concern in the municipal market."

Meantime, some investors argue that current municipal-bond analyses don't take into account the liability of citizens in each state for their share of federal debt.

Investors typically look at the amount of debt a state holds compared with its economic output, known as the "gross state product."

In Illinois, for example, the ratio is about 4%. But federal government debt will be paid by individuals through income taxes and federal taxes levied locally, such as gas and highway taxes. This would make it more difficult to raise taxes to pay all these debts.

"Ultimately, you're going to support debt at a national level as well," says Lyle Fitterer, managing director who oversees municipal bonds at Wells Capital Management, a large investment firm. So, in reality, he says, Illinois owes 65% to 70% of its gross state product.

John Sinsheimer, Illinois director of capital markets, says the state isn't responsible for federal debt and therefore the national deficit doesn't affect its ability to pay bonds, though citizens are resistant to tax increases in general.

Fitch Ratings's ratings consider overlapping debt of local governments but not each individual's proportionate responsibility for federal debt, says Amy Laskey, a managing director at the ratings provider.

Fitch, along with Moody's Investor Service, recently recalibrated its municipal-bond ratings, to bring them in line with other securities, such as corporate and sovereign debt. This lifted the ratings of thousands of municipalities.

The move was designed to balance municipalities' historically low default rates with increasing financial obligations and declining tax revenue.

It also helped reconcile municipal ratings with those of corporations, potentially lowering municipalities' borrowing costs and making municipal-bond navigation easier for investors who typically buy corporate bonds.

Of course this doesn't need to indicate anything is wrong with all municipalities [due to the way the MCDX is structured], but if the ABX family is any indication as to how these indexes can help in predicting the next massive implosion, we are in for a heap of trouble.

The problem is that municipalities income depends mostly on RE taxes; and since the rate of foreclosures is steadily climbing for the past 2 years [with no indication it will change direction] it is expected municipalities will have a harder time issuing new debt, and servicing the old one.

The problem is more than evident if one takes a closer look at California, New York, New Jersey and Michigan. The annual deficits can not be managed any longer and some really hilarious methods are employed to pay for old liabilities.

But the problem with MCDX as a trading vehicle is that, although it was announced as the next big thing in the derivatives market when it debuted, the chronic lack of liquidity displayed in the market when the spreads are this high made it good only to serve as an arbitrage vehicle.

It has diverged from CDX.NA.IG significantly and instead of becoming a way to trade muni debt risk it has become a laughing stock and an arbitrage opportunity in case of a doomsday event. 

It is easy to see why that is so. Even AAA IG debt risk should, theoretically, trade wider than any debt risk which is serviced by taxation; since muni debt is practically a form of sovereign debt. But with the implosion in housing that order of things has decoupled seriously and my belief is that the market is now irrational and that in the end AAA IG will trade wider than muni debt. 

I base my belief on the expectation that the Federal Government will either be used to enhance municipal credit or the FED will structure a facility similar to Maiden Lane which will accept municipal bonds as collateral. One, less possible, outcome is that an SPE, fully backed by the Federal Government [Treasury or the FED], will be created and take muni debt off banks balance sheets.

Of course this is yet not required due to accounting practices which are currently being used in asset valuation, but if the structured instruments [with cash flows coming from municipal IR payments] start to show a rapid deterioration in their cash flows, the contagion could spread and there are ways [easier than to play the MCDX indexes] to bet on single names and/or legacy tranches [legacy tranches being most likely hybrids consisting not only of municipal debt, but various other instruments such as CDOs, CLO etc etc]. The contagion due to the problem with muni debt could be several times greater than what we have seen in the fall of 2008.

This is the outline of the MCDX structure [for informative purposes only]:

And just to add more insult to the injury; there is this:

Eight U.S. states, including Illinois, California, Pennsylvania and New Jersey, risk lower credit ratings because they lack completed budgets less than three weeks before the start of their new fiscal years. A ninth, New York, has operated without one since its year started April 1.

All are gripped by political stalemates over how to cope with a collapse in tax revenue that included a $67 billion decline in the 12 months ended June 30, 2009, according to the Census Bureau. The Nelson A. Rockefeller Institute of Government called that the biggest on record.

Governors and lawmakers already chopped billions of dollars from previous budgets in the deepest recession since the Great Depression. Delays in new spending plans could cut off credit and slow payments to schools, local governments and public employees, Moody's Investors Service said. Some states may need emergency solutions like California used last year, when it paid vendors with IOUs as a $26 billion budget gap went unresolved.

Read the rest of the article here.

If you are interested in what kind of practices WS banks used in order to collect their fees issuing muni bonds, you only need to read the article Matt Taibbi published in Rolling Stone. You can find it by clicking here. 

Expect for the problems in municipal market to replace European debt problems and take the central spot in MSM headlines. Of course, every major economist, banker and CEO will tell you "no one could foresee these problems 2 months ago". They will be wrong. 

So, ladies and gentlemen this is it from me for the foreseeable future. I will go back to writing on a more regular basis when the WC is over and/or extreme events grasp the arcane world of derivatives and debt. 

Until then, good luck and Godspeed. 

P.S.

Go Deutschland. 

Comments

[Cheeky Bastard]

Fitch downgraded IL today from A+ to A.

The index has widened by nearly 45bp in the month of June alone, reflecting increased concerns over this debt. That was typified by trading in last Friday's session in the US. A downgrade by Fitch of the State of Illinois' debt, one notch from A+ to A, with a negative outlook caused its CDS to trade out 17bp to 283bp at 14.43pm EST, according to a note from Markit at the time

http://www.efinancialnews.com/story/2010-06-14/municipal-bond-spreads

[Careless Whisper]

I will go back to writing on a more regular basis when the WC is over

July 12? no. no. no.

[Cheeky Bastard]

I will publish now and then; but not everyday. 2-3 times a week tops; but I will still comment and all that. Its not like my writings are Pulitzer material goddammit. 

Im just not going to write pieces that take plenty of research time [like the CMBS one from couple of days ago]. 

Futures charts now and then. Well, Robo can do that if he wants to.

[Millivanilli]

Thanks Cheeky,

I love reading your stuff along with most of the other folks who contribute at zerohedge.  

[Kali]

Yes, thank you.

[sheeple]

Cheeky thanks for the analysis.

[Thoreau]

Next stop: 14 Trillion by the end of the year. Screw 'em. Anyone who continues to pay federal taxes is an enabler and a traitor.

[MatrixSurfer]

I too, have concluded it is immoral to pay taxes to this immoral government.   

[Greed21]

I have thought the same thing; we should give them a small taste.  If everyone risked a small penalty and stopped paying taxes for a year than they would stop their bullshit of giving our money away...