Tuesday, May 19, 2009

The Municipal Bond Market - A Disaster Waiting To Happen

I first put this post together back in 2007. I never posted it but started to rewrite it again in February of 2008. That is where it sat for various reasons. I have reswizzled the post for relevancy but the substance behind the post still exists.

Since 2007 I have gone back to this link to San Fransisco real estate from time to time. In 2007 there were 700-odd residential listings of foreclosure. Then in February of 2008 there were nearly 1,000 and today that number has been floating between 1,200 and 1,400. The data is likely dirty to some degree but regardless, it's likely to be consistently inconsistent. In other words, the accuracy is likely to be consistent in its error but the trend is likely to be more accurate.

Let's say the average property price in the link above is $500,000 just for argument's sake. That is $700 million in defaulted residential real estate in eight zip codes of one city. At real estate property tax rates of 2%, that's $14 million in lost property tax revenue. That's for 1,400 properties. Remember folks, 14 million homes are sitting empty right now. And, there are millions more either late or not paying their taxes. Washington is financially backstopping municipalities and states right now. To a certain degree there is obviously an ability to do so. Albeit temporarily. But, if this country's economic policies aren't changed, Washington is simply burying itself in debt.

What originally led me to dust this post off back in February of 2008 was a Wall Street Journal article citing historically low default rates for municipal bonds. ie, By implication municipal bonds represented a safe haven. Something that the yapping pundits are always quick to point out yet what we have highlighted as a fallacy. Remember, how often have we had such a mounting strain on municipal finances in the form of commercial & residential real estate tax receipts, lost jobs, personal & corporate bankruptcies, profligate municipal mismanagement & fiscal irresponsibility and a less than favorable debt market? In a post war economy, the answer is never. Not even close. The strain placed on municipalities today has absolutely no modern day context. So, pumping municipal bonds is nothing more than uninformed rhetoric.

Let's look at municipal bond performance when we had macro factors most comparable to today. Not the same. But more comparable than at any time in the last one hundred years. That would be the Great Depression. Because regardless of what cheerleaders say, this crisis is still metastasizing and worsening as I type this. So the calls for this not being a depression are very premature and again simply rhetoric. Emerging markets are already in a depression regardless of the rhetoric to the contrary. The U.S. has the wherewithal to avert catastrophe but seems unable or unwilling to acknowledge the changes necessary to do so. So, it too drifts down the road of inevitability as time runs out.

In the last one hundred and seventy years, there appears to have been approximately six thousand municipal bond defaults in the U.S. About five thousand occurred during the Great Depression.

So, what prompted me to dust this off and finally post it? Simple. Swap spreads in the municipal bond market have become utterly stupid. Never in their twenty year existence have they been this tight. Not even close. (Swap spreads are simply a fancy measurement that tells us there is no risk premium left in the municipal bond market. Just like the stock market before its collapse. ) These spreads aren't sustainable in a good economy, let alone a crisis with no modern day context. Not only is the municipal bond market a probable disaster waiting to happen, but so is the lucrative municipal derivatives market Wall Street crooks have created to prey on unsuspecting municipalities. Derivatives that, as this crisis hit, didn't work as billed. Municipal derivatives therefore represent a major risk as well. What a surprise. More Frankenstein finance. And what an unholy mess.

The behavior of markets has been text book. As investors play out their standard procedures in times of risk. Rush to certain asset classes in anticipation of safety. Whether that is value stocks, dividend paying stocks, municipal bonds, high quality corporate bonds or even Treasuries. It is therefore no surprise that the investor class would run to the safety of markets backstopped by the Federal Reserve and Treasury. It's part of the same delusional confidence mindset that led these same people to believe the Federal Reserve was going to save the economy from recession back in 2007 and even 2008.

And, if the municipal bond market cracks, one can almost imagine what impact it will have on equities. Needless to say, it won't be constructive.

The added strain on the municipal bond market caused by bankster shenanigans outlined in the linked text below only makes matters worse. It is still quite apparent very few actually understand the definition of risk. Or the monster Wall Street and Washington has created. Yet. They will. When it's well beyond too late and they have lost more of society's savings and wealth in the process. In other words, while this crisis has destroyed tremendous wealth to date, there is still an opportunity to start rebuilding a new economic model based on sound fundamentals. And, to save much of society's remaining wealth. Instead, it appears we will witness conscious and completely wrong actions of Wall Street professionals and politicians (called policy) on a go forward basis that will very likely make this crisis an unholy hell by the time it has passed. Time is running out and we still have no semblance of economic policy leadership in this country.

Graphic of current municipal bond swap spreads

Because they are private agreements, no comprehensive data exist on how many municipalities are involved in the almost $400 trillion interest-rate derivatives (swaps) market or the total paid to exit the contracts.

JPMorgan said in September it would stop selling derivatives to states and local governments amid federal probes into financial advisers and investment bankers paying public officials for a role in swap agreements.

Borrowers “never put a value on the risks associated with the swaps,” said Joseph Fichera, president of New York-based Saber Partners LLC, a financial adviser to corporate and public sector borrowers. They only estimated the savings investment bankers and advisers were telling them they would get, he said. (What a surprise. The Wall Street banksters have left no stone unturned in their efforts to steal everything from society.)

The use of swaps began faltering in February when the market for auction-rate securities collapsed. States, local governments and nonprofits sold about $166 billion of the debt, and as much as 85 percent of that was then swapped to fixed rates, according to Fichera.

posted by TimingLogic at 7:27 AM