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The Problem With Munis: CDS
Big dump in Muni world of late. As previously
noted there are many factors influencing pricing. Declining credit
quality and increasing supply are the big issues. But there is more at
play in this story than just the traditional fundamentals. The wild card is our old friend CDS.
There are today two ways to play the long side of taxable Munis. The easy and
old-fashioned way is to simply buy them. Once you own them you get a
semi –annual yield; in return you assume the risk of default of the
issuer.
Alternatively one could just buy a Treasury bond and write a CDS
contract on the municipality in question. In this transaction you would
get (A) the yield on the Treasuries and (B) a stream of income from
writing the CDS contract. The risk parameters are similar to actual
ownership of the muni bond. If there is a default, the CDS writer
assumes the loss.
Now consider the current pricing for Illinois GO bonds. (example from Bond Buyer)
Five year yield on IL Muni=2.85%
Five year yield on Treasuries=1.53%
Five year return on writing IL CDS=2.91%
Do the math. You could either invest your money at 2.85%, or you could
concoct the same economic result through a CDS contract and get a net
yield of 4.44%. Not hard to figure out which one make more sense.
Of course it is not so easy to write CDS. You must be a big player to do
something like this. Warren Buffet and Goldman can do it. So can a
bunch of others. But the list is still pretty short.
Market makers are not investors. They are arbs. When powerful street
players see market holes like this they just try to exploit it until it
is gone. The question at hand is, “What side of the market is wrong?” Either (I) Muni yields will rise to eliminate the spread, (II) CDS pricing will fall, or (III) both sides of the equation will move toward the center and a more efficient price will be established.
My bet on the outcome? Muni yields are set to go higher. Demand for Muni
CDS protection will remain firm. When a street player writes a CDS
contract for a Muni what do they do to lock in a gain and offset the
risk? Simple, they just short the underlying Muni bond. The net result of the CDS demand is that bond prices fall and yields rise.
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Bruce, I concur with moneymutt, thanks for the education.
There's a slight flaw with your analysis. The coupon on the muni is not taxable. The income on the treasury and the cds are both ordinary income. For an investor in the soon to return 39.6% tax bracket, the muni has a much, much better yield. I'd also point out that for a variety of reasons, the valuation of the CDS and the cash muni bond can diverge for a variety or reasons under certain circumstances.
i agree with Mr. "Nulceonics" here. Using treasuries as a way to "short munis" is crazy. if tax rates suddenly soar those munis will be worth far more than treasuries even in the fixed space. and if those treasuries are in a bubble talk about "egg foo yoong on face." moreover "why not just stop paying your taxes as a way to short the market"?
Actually, the post is about going long muni's synthetically. If you wanted to short muni's you'd just by the CDS (rather than write it) or more easily, just short one of the many ETF's or closed end muni funds. (Though the pricing of munis in a dislocated market makes that a bit dicy)
As you suggest this is a complex transaction. This is what I said:
There are today two ways to play the long side of taxable Munis.
These are BABs. A relatively new form of Muni created out of the 08 stimulus package. These are not tax advanged bonds.
This is not my conclusion. The link to the BB story may clarify? And yes, any leg of this can vary in cost as a result of independant variables.
bk
Thanks for the post.
BTW, NB had a great piece this month about the Colorado vote and some 19th century history on IL bonds. Really nice one and a half pager.
Good point, though the BAB's are gone. The chances that they get renewed are about the same as Obama and Palin running in 2012 as the national unity ticket.
Sounds like a monopoly, incentive to scale and disincentive to small, which provides all our employment.
Exactly what we don't need.
Ahem. Maybe I am out of date, but aren't Muni yields artificially depressed because of their tax-exempt nature? So the correct comparison should be between either:
i) the post-tax return on the Muni versus the post-tax return on the Treasury+CDS combo; or
ii) the pre-tax equivalent return on the Muni (i.e. un-grossed) versus the Treasury+CDS combo.
I'm not an expert on the current marginal tax rate on US investors, but, say it is 35%
Then the long the Muni earns you 2.85% post-tax, while the Treasury+CDS earns you 4.44% pre-tax which equates to 2.89% post-tax.
Now where is the arbitrage?
I think you are out of date a bit. There are many Munis that trade through Treasuries. But that is not the issue. The arb is with taxable Munis. BABs.
with Muni's you want to scrutinize the entity, like Jeff County Miss. Also how well represented are they on K street, I mean Congress? and of course you can really put on teh arb if you own the etf of a Muni fund? Personally it all stinks, but I see cities spending money out of their redevelopment fund, with one hand, while they close schools and turn off street lights with the other.
Amazing that the Illinois Muni is that low - I sure wouldn't buy it (I live in Illinois). Also, I would think you have a tax consequence on the CDS portion that you don't on the other two?
What if you were to pair off different credit rated munis instead of using a Treasury long vs. AAA+ muni long ?
My only issue is that I agree that the muni market is still richly priced and that risk is not priced in to the extent that yields will rise. However, there would be a better correlation with a muni vs. muni against a treasury vs. muni.
From the Bond Buyer piece: Yet municipalities historically exhibit lower default rates than corporations in every rating category, and have a higher recovery rate in the event of default.
They used to say similar things about residential mortgages. Likewise, I think this will prove to be a that-was-then-this-is-now type phenomenon.
Most municipal credit is very local and very specific -- bond insurance made it look, for a while, like this wasn't true -- everything was fungible AAA. There are and will be strong deals out there -- defeased bonds backed by 100% treasuries, for instance. I know of a refunding Hotel Tax Bond, when first done 15yrs ago 2.5X coverage, revenues to debt, now, at the time of the refunding, it is 6X -- yes in the current market. That sort of thing is everywhere for those who have the time to look. Personally of course I wouldn't get out the curve on anything since I think currency debasement and hyperinlation is a big downside risk and with rates as these levels I don't see much upside cap gains-wise.
But my point is that it doesn't make sense to trash the whole sector on a credit basis.
Well heavens, if you're going to actually get into the guts of Muni market, you have to understand that it's the most corrupt of ALL markets. Municipalities are run by the bond dealers, who think up projects and then have the politicans approve them so the dealers can manage the proceeds and sell the bonds.
The underlying economic fundamentals of Muni bonds are nonexistent. Here's some literature on this can of worms (and of course, just Google municipal bonds corruption):
1 Corruption and Municipal FinanceAlexander W. Butler
Rice University - Jesse H. Jones Graduate School of Management
Date Posted: August 16, 2004
Last Revised: August 26, 2008
Working Paper Series
368 downloads 2 Corruption, Political Connections, and Municipal Finance
The Review of Financial Studies, Vol. 22, Issue 7, pp. 2673-2705, 2009
Alexander W. Butler , Larry Fauver and Sandra Mortal
Rice University - Jesse H. Jones Graduate School of Management , University of Tennessee, Knoxville - Department of Finance and University of Memphis
Date Posted: June 22, 2009
Last Revised: July 29, 2010
Accepted Paper Series 3 Corruption, Political Connections, and Municipal Finance
AFA 2008 New Orleans Meetings Paper
Alexander W. Butler , Larry Fauver and Sandra Mortal
Rice University - Jesse H. Jones Graduate School of Management , University of Tennessee, Knoxville - Department of Finance and University of Memphis
Date Posted: March 22, 2007
Last Revised: August 29, 2008
Working Paper Series
434 downloads 4 Do Campaign Contributions and Lobbying Corrupt? Evidence from Public Finance
Gajan Retnasaba
Independent
Date Posted: August 2, 2007
Last Revised: August 5, 2007
Working Paper Series
175 downloads
Right, residential RE remains and always has been "very local" too despite attempts in that market to make everything fungible AAA. I know a smart, avid muni buyer who has never bought into the added "safety" of insured munis on the grounds that it wouldn't take much to make them unable to pay out claims (and therefore not worth the cut in yield) - a view recently substantiated when similar bond gaurantors wiped out in the subrime mortgage mess.
The CDS market is pretty new and already has a bigger history than the muni market does of shitting the bed (AIG et al) even though things kinda sorta all worked out in the end. I wonder if expected additional friction on the road toward being made whole could explain why the synthetic long muni (via CDS) trade yields more than the real thing.
Things sorta worked out only because the Fed/UST propped up AIG. AIGs counterparties were saved from the consequences of their INCOMPETENT credit underwriter of their counterparty (AIG). That's kindest assessment. The darker one is that they knew they were TBTF so it didn't matter.
Another problem in muni land, mostly ignored now are all the predatory, abusive, inappropriate derivative deals that have been done. The San Francisco Asian Art Museum on the brink of bankrupcy is a good example.
Funny how this WSJ article from Nov 16 begins with:
SAN FRANCISCO—The Asian Art Museum here is facing a financial crisis, the latest—and one of the largest—in a string of museums to suffer from problems amid the weak economy.
Farther into the article we get to the real reason:
For the Asian Art Museum, donations and income from visitors have remained healthy, Mr. McLoughlin said. But after refinancing the fixed-rate debt in 2005 to a variable-rate loan, the bond's insurer, MBIA Inc., had its credit rating downgraded in 2008 during the financial crisis.
That caused the museum's loan interest to skyrocket, at one point hitting 9%, Mr. McLoughlin said. The museum temporarily fixed the situation by getting a letter of credit from J.P. Morgan assuring that the bonds were a safe investment. That letter is set to expire on Dec. 21, Mr. McLoughlin said, raising the prospect that the museum's payments could rise.
Good 'ole JPM dirty paw prints all over it -- they know a soft target when they see one.
They have some nice pieces in that museum--hope to see them on Ebay.
I think Asian Art Museum is city-owned. At least their employees are city employees. You can't expect the San Francisco economy to fall apart and not have the Asian Art Museum go down with it.
Also, Asian Art Museum has lousy exhibits--no imagination, rather trivial.
And not a SINGLE piece of Ru ware!! Avery, what happened???
No Kenzan either.
Thanks Bruce ,
At the end all boils down to a big giant Casino about 60 trillion dollars in size.
When one of the players fail ( eventually will), everybody will fall like dominoes, market will crash . Until the music stops everybody will dance..
Think I'll call BB and see if he will loan me a billion so that I can sit at this table for a few hands.
Is there anyway of knowing reliably the size of CDS positions and short positions against a given issuer?
IxNay. This is all OTC. But I will say this, The amount of CDS outstanding is a very small fraction of the total Muni bonds outstanding. That may be a factor in the pricing.
Thanks.
And that's the problem. None of this should be OTC. And this shouldn't be a game that only big players can engage in. And credit default swaps shouldn't even be allowed to exist.
When an arb seems too big to be an arb, it usually is.
Positive CDS-bond basis is usually due to limited supply of bonds, which is clearly not the case for munis now. My best guess is CDS dealers trying to unwind their short CDS positions and bond holders scrambling to buy protection -- remember munis yielding barely above treasuries a month ago? It may be a false arb if every eligible CDS seller is balls deep on the short side -- nobody can afford to take advantage of it until you get hedged, thus the rush.
Well, one item omitted is the possibility of having to pay up on the CDS when the muni defaults, and reserving funds for that eventuality. I suppose the treasury bond is the "reserve" in this example, but for the "players" my belief is that possible CDS payout liabilities are considered contingent enough that there are no reserves. I would suggest the pricing of the CDS in the example above is quite possibly underestimating risk.
And in the example, who has an economic incentive to buy CDS protection? The yield is less than the cost of CDS "protection."
Aren't there 3 ways? ETF exposure to bonds (which is flagging and also part of the dip)?
Would it not be better to naked short sell for them. Collect spred and have free protection.
How do they "short the underlying Muni bond?"
those guy can even short the weather forecast. It's not up to us to understand. Theirs neither actually...
Actually China claims they can manipulate local weather conditions....so yeah if you can control it one way or another, you can definitely short it.
A layup. Done in size every minute of the day. No different than any other market. You borrow the underlying and sell it for cash. A reverse repo.
Again, this is not something that your average Joe could do. You have to be a player to sit at this table.
2.85 non taxable vs 4.44 taxable. 4.44 -4.44 x (36% fed tax)=2.84 which is the same return for ordinary taxpayers.
Spot on. No arb opportunity for the players that are able to do this sort of thing in the first place.
Thanks, Bruce, I didn't know that. And naked shorting muni bonds? Phantom supply, wow. I suppose at these rates it's not very expensive to pay the interest on the bonds either. But destructive and predatory too when you consider it's raising rates on already squeezed local governments. Buffet's in this too? And what medal did he just get?
Hmmm. I am not so happy with your description. Naked shorting is not what this is about. This is about an arb that is influencing the market for the time being. It will go away. In the mean time some folks will have longs and shorts on to manage liquidity and risk. That is the way it works.
What is the mechanism for shorting munis?
Does one have to secure a borrow, or not?
Is the short interest limited by the float of that particular muni issuance or not?
What is the relative size of the synthetic muni market (treasury/CDS) vs underlying market?
Understood - I don't mean to divert the discussion, just trying to expand my knowledge of these obscure forces in this market.
But it is part of what's happening, naked shorting of MBS allowed for creation of CDS on non-existent mortgage-backed securities. The CDS market grew larger than the base of mortgages. No one has wised-up, that will happen in muni's too.
Not only that, Wall Street is into counterfeiting (naked shorting) pretty much everything under the sun. They sell 100 times the gold and silver contracts that actually exist, the whole CDO fiasco was counterfeiting MBSs and selling the counterfeit MBSs as CDOs. They do it every day with ALL commodities. They care nothing about actually owning something before they sell it ... stocks, same thing. The big banks are allowed to naked short for liquidity purposes and there is no teeth in Reg SHO ... it is just a joke.
It seems that if the banks do not think the economy is big enough to support their already blated salaries, they just create a phantom casino gambling economy on top of the real economy and then have the lawmakers make it legal or convince the "pet" SEC to look the other direction.
And, people wonder (not) why there is no trust in the markets!
Bruce, thanks for the explanation...interesting.