Speculators have long been able to short-sell stocks, making money when share prices fall.
But derivatives are now making it possible to short municipal bonds.
If you think you are the first to determine that New York’s budget is going to suffer because of the financial crisis, then you, too, can wager on it.
The world of municipal finance has many hidden weak spots because governments are required to disclose far less about their finances than companies are.
“There are hedge funds that already, for at least a year, have been getting into this,” said Douglas A. Love, an economist and a member of New Jersey’s State Investment Council, which oversees the investment of that state’s pension fund.
This form of market betting could force local governments to face up to long-simmering problems instead of sweeping them under the rug.
But it could also increase the cost of raising money or, in an extreme case, drive investors away entirely if a city’s finances are perceived as shaky.
Already, the housing slump has left some places struggling to balance their budgets as revenues dwindle and the credit crisis takes its toll.
Credit-default swaps are essentially a form of insurance. Bond investors can buy the swaps to protect themselves in case the issuer fails to pay its debt.
But the swaps can also be used to speculate on the creditworthiness of an issuer, whether a company, a state or some other body of government, like a turnpike authority.
The weaker its finances become, the more the value of the swap rises.
The municipalities in play tend to be those that issue a large number of bonds and are familiar to investors.
Statistics on trading volume are not publicly available.
But market sources said that swaps are traded to protect about $1 billion to $2 billion of municipal bonds each week, double the volume a year ago.
The municipal [or muny] bond market has been reduced to gridlock in the last couple of weeks by the financial crisis.
Even when the market returns to more normal conditions, state and local governments could face additional scrutiny because they share some of the characteristics now clouding financial institutions.
With:
• great latitude in their accounting practices,
• poor enforcement of the rules, and
• a big dose of actuarial science,
some states and cities appear to be running big [opaque] pension funds.
“This kind of nontransparency is precisely what has landed us here” in the credit crisis, [another economist] said.
“If you’re not transparent, …you’re borrowing money from the investing public without fully discharging your fiduciary duty.”
Market sources said it would be impossible for traders to “blow up” a city or a state with credit-default swaps because governments do not issue stock.
When traders have helped drive companies to destruction in the last few weeks, they have generally used complex strategies that combined stock positions with credit-default swaps.
Lehman Brothers, which declared bankruptcy last month, was one of the largest market makers in municipal credit-default swaps, along with Citigroup, Goldman Sachs and Merrill Lynch.
Municipal credit-default swaps, created in 2004, mostly gathered dust until 2007. After the insurance companies that specialized in municipal bonds became troubled, credit-default swaps emerged as an alternative form of insurance.
Even though municipalities rarely default on their bonds, the insurance was popular because it made municipal bonds seem utterly foolproof.
That sense of heightened security made the bonds easier to sell, lowering communities’ borrowing costs.
[In] Vallejo, CA, the city ran out of money after promising its police officers and firefighters much richer benefits than it could afford.
That filing created more interest in municipal credit-default swaps. It also cast a bright light on the possibility that some governments had promised benefits they could not pay, even though their financial statements and credit ratings seemed fine.
Mr. Love, of the New Jersey investment board, has recalculated the value of the pensions promised to the state’s public workers.
He found a $56 billion deficit, more than three times the $18 billion that the state was disclosing in its bond-offering statements.
“The thing you’re sensing is that the capital markets are in one world, and the actuaries and bond counsels and the legislators are in another world,” Mr. Love said. “And that sounds like an arbitrage opportunity.”
Agency’s ’04 Rule Let Banks Pile Up New Debt
New York Times, October 3, 2008
“We have a good deal of comfort about the capital cushions at these firms at the moment.”—Christopher Cox, chairman of the Securities and Exchange Commission [SEC], March 11, 2008.
As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets—more than enough to weather the storm.
Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase—backed by a $29 billion taxpayer dowry.
Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom:
• Merrill Lynch sold itself to Bank of America,
• Lehman Brothers filed for bankruptcy protection, and
• Goldman Sachs and Morgan Stanley converted to commercial banks.
Many events…have led to what has been called the most serious financial crisis since the 1930s.
But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control.
The [SEC]’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that…afternoon, the five members of the Securities and Exchange Commission met…to consider an urgent plea by the big investment banks.
[The banks] wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on.
The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments.
Those funds could then flow up to the parent company, enabling it to invest in:
• the fast-growing but opaque world of mortgage-backed securities;
• credit derivatives, a form of insurance for bond holders; and
• other exotic instruments.
The five investment banks led the charge, including Goldman Sachs, headed by Henry M. Paulson Jr. [In 1996], he left to become Treasury secretary.
A lone dissenter—Leonard D. Bole, a software consultant and expert on risk management—weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. [He argued] the computer models run by the firms—which the regulators would be relying on—could not anticipate moments of severe market turbulence.
[Bole] never heard back from Washington.
One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told—those with assets greater than $5 billion.
“We’ve said these are the big guys,” Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”
The [one-hour] proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.
[The vote to pass the exemption] was unanimous.
The decision [to change] what was known as the net capital rule was completed and published in The Federal Register a few months later.
With that, the five big independent investment firms were unleashed.
In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the [SEC] also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.
Over the following months and years, each of the firms would take advantage of the looser rules.
At Bear Stearns, the leverage ratio—a measurement of how much the firm was borrowing compared to its total assets—rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt.
The 2004 decision for the first time gave the SEC a window on the banks’ increasingly risky investments in mortgage-related securities.
But the agency never took true advantage of that part of the bargain.
Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
“The last six months have made it abundantly clear that voluntary regulation does not work,” Cox said.
Cox has said the 2004 program was flawed from its inception. But former officials as well as the inspector general’s report have suggested a major reason for its failure was Cox’s use of it.
“In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the SEC didn’t oversee well enough,” Goldschmid said in an interview.
He…left the commission in 2005.
Cox…said that by last March he had concluded that the monitoring program’s “metrics were inadequate.”
He said that because the commission did not have the authority to curtail the heavy borrowing at Bear Stearns and the other firms, he and the commission were powerless to stop it.
“The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness.”
But critics say the commission could have done more.
Additional note from this article:
In addition to dismantling “a risk management office [at the SEC] that was assigned to watch for future problems,” Cox failed to challenge a plan by Henry Paulson, Treasury secretary and former head of Goldman Sachs, “that proposed to reduce” the stature of various financial regulatory agencies, including the SEC.
“While other financial regulatory agencies criticized [the] blueprint by Paulson,” only former SEC chairmen stepped up “to complain the blueprint would neuter the agency.”