May 7, 2008

Big excitement for US Municipals as Vallejo, California, intends to enter bankruptcy:

The city council’s unanimous decision makes the San Francisco suburb the largest city in California to file for bankruptcy and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in 26 years.

The city of 117,000 is facing ballooning labor costs and declining housing-related tax revenue that have left it near insolvency. The city expects a $16 million deficit for the coming fiscal year that starts July 1. Under bankruptcy protection, city services would keep running. It would freeze all creditor claims while officials devise a plan for emerging from bankruptcy.

The area has been one of the hardest hit in Northern California by the housing market slump. Home prices in Solano County, where the town resides, dropped 19 percent in January from the year before, according to DataQuick Information Systems, a firm which tracks real-estate markets in the state.

This ties in nicely with the report from Accrued Interest that MCDX has commenced trading:

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we’ll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody’s Global Scale, the one where Moody’s attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.

buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.

To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

To me, this product sounds like just another speculative recipe for disaster.

In the first place, consider the theoretical underpinnings of the CDS market: if I buy a 5-year corporate for cash and then buy credit protection for it, then what I’ve got – to a first approximation, ignoring liquidity effects – is 5-year bank paper.

If I buy 5-year bank paper and sell credit protection, then I’ve got – first approximation – full exposure to the corporate bond.

But there are tax effects with munis, since their coupons are not taxable, which is why (in normal times) they trade through Treasuries. Buying bank paper and selling municipal credit protection means I have to worry about tax effects and cash flow differences. Hence, there is no natural seller of municipal credit protection.

The other problem with the contract is that it is entirely cash settled – there is no mechanism whereby I can exchange for physicals. If I take a position on a bond future, I can sit on it until the last delivery date, when I will either take or make delivery (I might be forced to take delivery earlier, if I’m long). This enforces convergence between the cash and futures markets. But nothing of the kind happens with MCDX … I cannot sit on my 100-million position and, when it comes due, elect to take or make delivery of 50 x 2-million CDS contracts of the underlying.

Why is this important? Well, we’ve seen what’s happened in the ABX markets, as the Bank of England has followed PrefBlog’s lead and pointed out that ABX prices are connected to reality only in the very loosest sense.

So … we’ve got a market that I predict will quickly become dysfunctional. Speculators and hedgers will be buying up vast quantities of contracts and forcing the prices to dizzying heights, probably with ludicrous gyrations. Those willing to take a short position from time to time might – if they restrain themselves and don’t over-lever – just might do very well out of this.

Accrued Interest follows up with yet more US municipal news:

UBS is exiting the muni business, and are looking to sell the unit. They were the #3 underwriter, so it would have to be someone quite large to buy the business. Let’s see, who among the large dealers doesn’t have much in munis? I know! Bear Stear–… Er… Actually I don’t know who the hell will buy UBS’ muni unit. If they do want to make a move they need to do it fast. Otherwise rivals will start picking off the best muni bankers one by one until finally there is nothing left of the unit worth buying. One reader and I had a off-line chat about this and he suggested that there could be a re-regionalization movement in municipals. In other words, a movement away from consolidation in New York and toward mid-sized dealers gaining more power in that market. Lately spreads (meaning commission spreads) have been wider, especially in secondary trading. If that keeps up, look for regional brokerages to benefit.

I know! As briefly discussed on April 22, Bank of Montreal has recently become “the sixth-largest bank qualified municipal bond dealer in the United States and the largest in Illinois” … they might be interested! Of course … they might be even more interested in becoming one of the rivals picking dealmakers off the UBS desk one by one …

There was a long discussion on April 29 about the Fed’s plans to pay interest on reserve balances; today Bloomberg reports that:

Fed staff started discussions this week with Congress about bringing forward the date that interest can be paid, the person said on condition of anonymity. Technical details of how the program would work, and what rate the Fed would pay, would likely need further study and discussion by the FOMC, the person said.

If the Fed paid an interest rate equal to the federal funds rate, commercial banks would avoid dumping any excess cash into the money market, which in the past has driven rates below the Fed’s target.

The New York Fed bank’s Open Market Desk is charged with buying and selling Treasuries with 20 Wall Street securities firms to keep the main rate close to the target set by the FOMC.

The desk has struggled to keep the federal funds rate stable as banks attempted to manage their reserves at a time when credit markets were seizing up.

On May 2, the federal funds rate ranged from 0.1 percent to 2.5 percent even though the target was 2 percent. On April 23, the rate fell as low as 1 percent and rose as high as 10 percent, compared with the then-target of 2.25 percent.

“The inter-bank interest rate is going to be stabilized with this policy,” said Marvin Goodfriend, a professor at Carnegie Mellon University’s Tepper Graduate School of Business and a former Richmond Fed policy adviser who has published research on interest on reserves.

Assiduous Readers will remember my prescription for the US mortgage market:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

  • 30 years in term
  • refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
  • non-recourse to borrower (there may be exceptions in some states)
  • guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
  • Added 2008-3-8: How could I forget? Tax Deductible

… which was referred to on March 18. The call has been taken up (in part) by Thomas Palley, “an economist living in Washington DC” (hat tip: Naked Capitalism):

First, the capital gains exemption should be abolished for all new home purchases. Instead, the base cost of houses should be indexed to inflation so that homeowners are not taxed on inflation gains. Existing homeowners should be grand-fathered under current law to discourage selling to protect unrealized gains, which would destabilize the housing market.

Second, the ceiling (currently $500,000 per taxpayer) on mortgages qualifying for interest deductibility should be gradually lowered to zero over a ten-year period.

Third, since everyone needs housing, the Federal government should phase in a refundable housing cost tax credit available to all, regardless of whether they own or rent.

I must admit, I don’t think the third point’s conclusion necessarily follows from the premise! But at least the issues are being aired.

There’s an interesting state of affairs at MBIA:

MBIA Inc. has yet to pass on $1.1 billion of capital to its insurance subsidiary, three months after raising the money to defend the unit’s AAA credit rating.

The cash, raised in a February stock sale, is being held at the parent company while Armonk, New York-based MBIA develops a plan for the company’s legal and operating structure, MBIA Chief Executive Officer Jay Brown said in a letter to shareholders released yesterday.

“Given the more than adequate liquidity in both our insurance and asset management businesses, there is no compelling reason to move this cash at this point,” Brown said.

MBIA was criticized by Fitch Ratings, which said on April 4 the decision raised the risk that the cash may not end up as capital for the insurance unit as MBIA had promised. While Fitch downgraded MBIA to AA from AAA, Moody’s Investors Service and Standard & Poor’s cited the capital raising as a reason for keeping the insurance unit at AAA.

Regulators are waiting for MBIA to contribute the funds, according to New York State Insurance Department Deputy Superintendent for Property and Capital Markets Michael Moriarty.

“It was never our expectation that the funds raised would go anywhere other than to the insurance subsidiary,” Moriarty said. MBIA spokesman Jim McCarthy declined to comment.

Jiggery-pokery, or simply flexibility? One way or another … if I was an MBIA counterparty, I’d be making sure their collateral was good!

And it looks like the big Wall Street dealers are going to have to lift their skirts a bit:

The U.S. Securities and Exchange Commission will require Wall Street investment banks to disclose their capital and liquidity levels, after speculation about a cash shortage at Bear Stearns Cos. triggered a run on the firm.

“One of the lessons learned from the Bear Stearns experience is that in a crisis of confidence, there is great need for reliable, current information about capital and liquidity,” SEC Chairman Christopher Cox told reporters in Washington today. “Making that information public can certainly help.”

We’ll see what the details are, but this is a good development for investors.

Unfortunately, due to complications arising from a symphony orchestra and a pretty girl, I am unable to report on the indices, issue performances or volume highlights tonight. Sorry, folks! Don’t you wish I had the HIMIPref™ indices all up to scratch, so that the bulk of the report generation would be a button-push? Me too. But I’ll update sometime tomorrow.

Update, 2008-5-8

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.01% 5.04% 44,877 15.40 1 -0.1995% 1,092.0
Fixed-Floater 4.72% 4.78% 63,288 15.82 7 +0.0073% 1,058.1
Floater 4.38% 4.42% 62,744 16.54 2 +0.6409% 861.0
Op. Retract 4.84% 3.37% 86,975 2.75 15 +0.0789% 1,052.6
Split-Share 5.28% 5.59% 73,679 4.16 13 -0.0157% 1,049.9
Interest Bearing 6.15% 6.34% 57,447 3.84 3 -0.1008% 1,101.4
Perpetual-Premium 5.89% 5.60% 149,109 6.41 9 -0.0524% 1,020.5
Perpetual-Discount 5.69% 5.73% 321,222 14.17 63 -0.0914% 919.7
Major Price Changes
Issue Index Change Notes
POW.PR.D PerpetualDiscount -1.6795% Now with a pre-tax bid-YTW of 5.82% based on a bid of 21.66 and a limitMaturity.
BNS.PR.K PerpetualDiscount -1.6689% Now with a pre-tax bid-YTW of 5.53% based on a bid of 21.80 and a limitMaturity.
NA.PR.L PerpetualDiscount -1.3679% Now with a pre-tax bid-YTW of 5.83% based on a bid of 20.91 and a limitMaturity.
HSB.PR.D PerpetualDiscount -1.0777% Now with a pre-tax bid-YTW of 5.75% based on a bid of 22.03 and a limitMaturity.
BAM.PR.B Floater +1.3151%  
BAM.PR.I OpRet +1.3460% Now with a pre-tax bid-YTW of 5.15% based on a bid of 25.60 and a softMaturity 2013-12-30 at 25.00. Compare with BAM.PR.H (4.96% to 2012-3-30) and BAM.PR.J (5.33% to 2018-3-30).
PWF.PR.E PerpetualDiscount +1.6522% Now with a pre-tax bid-YTW of 5.55% based on a bid of 24.61 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BNS.PR.K PerpetualDiscount 203,940 Now with a pre-tax bid-YTW of 5.53% based on a bid of 21.80 and a limitMaturity.
BPO.PR.H Scraps (would be OpRet but there are credit concerns) 170,400 Now with a pre-tax bid-YTW of 6.75% based on a bid of 23.74 and a softMaturity 2015-12-30 at 25.00.
BMO.PR.I OpRet 53,200 Now with a pre-tax bid-YTW of 0.77% based on a bid of 25.02 and a call 2008-6-6 at 25.00.
PWF.PR.L PerpetualDiscount 31,300 Now with a pre-tax bid-YTW of 5.71% based on a bid of 22.50 and a limitMaturity.
RY.PR.G PerpetualDiscount 31,230 Now with a pre-tax bid-YTW of 5.60% based on a bid of 20.15 and a limitMaturity.
BNS.PR.L PerpetualDiscount 28,910 Now with a pre-tax bid-YTW of 5.54% based on a bid of 20.48 and a limitMaturity.

There were eighteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

6 Responses to “May 7, 2008”

  1. […] #3: As reported on PrefBlog on May 7: And it looks like the big Wall Street dealers are going to have to lift their skirts a bit: The […]

  2. […] #3: As reported on PrefBlog on May 7: And it looks like the big Wall Street dealers are going to have to lift their skirts a bit: The […]

  3. […] drive to get authority for the Fed to pay interest on reserve balances (discussed on May 7 and April 29) continues with Bernanke writing Pelosi: Federal Reserve Chairman Ben S. Bernanke […]

  4. […] has filed for bankruptcy as indicated on May 7. According to Markit 10-Year MCDX closed at 49bp today, essentially unchanged from its opening […]

  5. […] MCDX index (of credit default swaps on US Munis; briefly mentioned May 23; aspersions were cast May 7) is being circled by vultures. Accrued Interest suggests a spread trade against corporates, but: I […]

  6. […] Fed’s ambition to pay interest on reserve deposits has been discussed on PrefBlog on May 16, May 7, April 29 and January […]

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