These are slugs. The one on the bottom is poisonous. You’ll find that
one in Australia. Not to worry about these slugs and all their kin. They
are doing just fine. It is more than likely that they will be around
long after “intelligent” life is gone.
The slugs that may be going extinct are referred to as State and
Local Government Securities. Those who use them
affectionately refer to SLGS as “Slugs”.
SLGS are another of those weird things that make up our gigantic public
sector debt. The total outstanding is about $210 billion. In the scheme
of things that is peanuts. It is only 2.5% of the public debt. But who
was it that said, “$200 billion here, $200 billion there….. Sooner or
later we are going to run out of buyers".
SLGS are the product of a law dating back to 1969. The law limited and
set rules for municipal bond arbitrage by large Muni issuers. It is (to
me) an interesting and somewhat comical story.
States are allowed to issue Municipal bonds that are free of both State
and Federal taxes. US Treasury bonds are fully taxable by the States and
the Feds. If you assumed a person was in a State where their effective
tax rate was 35% it would mean that a pretax Treasury bond yield of 5%
was equal to 3.25% after tax. So if that person could buy a state muni
that yielded 3.5% he would be well ahead on the investment (assumes no
credit risk).
This arbitrage works the other way just as well. The States were able to
issue long-term debt at 3.5% and invest in Treasury bonds with a
similar maturity at 5%. States pay no taxes so this was just a way to
coin money. And the States did just that all throughout the 60’s.
and a bunch of State treasurers were ginning the system and creating an
‘early days’ derivative transaction that generated free income. Amazing
how things have changed over the last half century. When it comes to
financial engineering, the techniques are new. The motives are the same.
So in 1969 a ‘going broke’ Federal government put an end to the party.
The SLGS were born from that.
SLGS have continued to provide an important role. They are used for
Municipal Bond Defeasance. Think of this as if you had a 6% mortgage and
now interest rates have fallen to 5%. You could (at least in the past)
refinance the mortgage and save yourself some money every month. States
are no different, but they face a problem. They can’t just pay off their
old bonds. Those bonds all have call protection features. So those
bonds can’t be prepaid or redeemed.
This is where the SLGS come into play. Here are the steps:
1) State has outstanding $10mm of a 10 year Muni at 5% callable in six
years.
2) State can now borrow at 4%.
3) State borrows $10mm for ten years at 4%.
4) State uses the $10mm of newly borrowed funds and buys SLGS from
Treasury that match the maturity of the old 5% bond.
5) State delivers the SLGS to a Trustee who receives future
interest/principal payments from Treasury and who will disburses it to
the old bondholders.
6) Upon the completion of #5 the old 5% bond is “defeased”. It is no
longer either a cash or accounting liability on the State’s books. The
State has achieved the desired savings in debt service expense and
extended the average life of its liabilities.
7) On the call date (six years later) the bonds are called. The SLGS
mature. The proceeds are used to pay back the bondholders. The Trust is
dissolved.
Now you understand SLGS. Here's why I think they are a dying breed:
-A State can’t defease an old bond if the cost of new borrowing is
higher that the old coupon.
-A State that was looking at a growing debt load would be nuts to
defease old debt. They have to raise new money to meet current
liabilities, forget about prepaying stuff that does not come due for 6
or 8 years.
-California is now borrowing at a premium to Treasuries. Many states
will follow their lead. That is the end of the SLGS arbitrage.
-The biggest issuers of Muni's (and users of the SLGS window) are also
the same States that are either now in trouble or are headed for
trouble.
Here are some reports on SLGS outstanding. It is headed south and will
continue to head south.
As the SLGS account runs
down, the liabilities will have to be replaced, dollar for dollar, with
“real” investors. The Chinese Central Bank, The Bank of England on
behalf of the Chinese Central Bank, or possibly the mystical
“households” and “others” will have to pony up for the increase.
Someone will point out that when SLGS mature an investor someplace gets
cash and that investor will go out and buy some Treasuries to offset the
shortfall. Sorry. It doesn’t work like that. Not when Ben B. has the
ZIRP on. There are far too many better things to invest in.
So, if I understand this right, T-bill yields going into the shitter will accelerate the SLGS problem? Ie., the upcoming flight to the dollar due to the euro crisis is going to fuck some shit up as far as state budgets?
The only thing slugs are good for is dousing in salt. <shudder>. They are my Kryptonite.
As to the defeasance question, excellent points. A downturn in defeasance also will hurt performance of muni bond funds. They get a reasonable amount of capital gain from the pop in price when a bond defeases, as it suddenly gets a AAA rating.
That's especially true for muni debt from a low-rated state, e.g., California. You get a nice bit of gain moving from A- to AAA. So without that option, muni bond performance will be harmed. Of course, the CA issues are much larger than that, but it is one more nail in the coffin for investors
Here in Europe, we eat Slugs in garlic butter! HHHhhhhmmmm... slightly grilled and with some garlic bread. I love slugs
where did you get the pictures of master bates . yipcarl, john Bravo.
where did you say the photos of these slugs were taken ?
can hardly believe my eyes . they must have been taken in the last day or so. .
filming the bottom of the scum pond
IMO, Krasting has the best content on the site. I'm glad that I paid my lousy fifty bucks to ZH to get access to those that teach what is really going on.
OK maybe I'm completely wrong but I'm not comfortable with your analysis, seems to me that the SLGS is balanced by a liability to redeem debt at maturity.
And if both go away there's zero cash effect.
Of course the State always seems to need to borrow more money but I don't think it's the paid down SLGS that should be held responsible!
Ha... entertaining and educational... classic...
very interesting, thanks for teaching us new things Bruce.
Your previous post below was one of my favorites.
http://www.zerohedge.com/article/usa-vs-gs-pot-calls-kettle-black#comment-319101
You are correct, the slugs will die and that is the one of my black swans that will push the govt. into doing drastic things to keep the people happy and/or distracted from the imploding economy. Once states can't get money, then they either have to borrow from the Fed (the fed doesn't want to do that because once they bail out one state all the Senators and Congressmen and women from other states will be lobbying for their state to be bailed out also.
Ditto - awesome factoids to ponder.
US Treasury bonds are fully taxable by the States and the Feds.
No reciprocity? I thought UST bond interest is state tax free and Muni debt interest is Fed tax free. No?
Correct.
Thanks for the schooling Bruce. You're a champ.
Fight night my money is on Bruce.
Sean Biggs feat. Akon- Never Gonna Get It:http://www.youtube.com/watch?v=n5eU5_0sIMk
Nice pickup on those changes. This is not large in the grand scheme of troubles, but it sure all adds up.
Coming to a community, county or state near you soon.
Cool pictures, Bruce. Very enlightening on the SLGS--was not familiar how these were a part of the Muni market. Loved your earlier piece as well. Thanks for all you do.