California issuing

December 18, 2009
Michael Marois's article will read the first five paragraphs, conclude that California got royally ripped off by the troika of JP Morgan, Citigroup, and Goldman Sachs, and move on.

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Who does Bloomberg think has the appetite to wade through 4,000 words on a single Californian bond deal in October? The answer is “probably no one” which means that most of the people reading Michael Marois’s article will read the first five paragraphs, conclude that California got royally ripped off by the troika of JP Morgan, Citigroup, and Goldman Sachs, and move on.

If you read the whole thing, however, it’s not nearly as simple as that: the bond deal in question was in many ways perfectly timed, from the point of view of a major issuer, coming right when interest rates were at their low point. And it was huge — $4.14 billion — which is far too big to do an auction deal where the issuer sells to the banks directly, rather than using them to underwrite an issue aimed at real-money investors. What’s more, California sold the vast majority of the bonds it wanted to sell, while other states, like Maryland and Minnesota, sold as little as 25% of their intended issuance.

Through the course of the article, I kept waiting for the other shoe to drop — to read some piece of information which indicated that California could have done better than it did. But it never quite got there. It’s undeniable that the banks made fat fees on the deal: the three banks between them made $12.4 million, and total fees amounted to $25.8 million, or 62.3bp. That seems expensive to me for no more than a couple of weeks’ work and no real risk. But here’s the bottom line: California got 30-year bonds away at 7.23%, even after paying a steep 325bp spread over Treasuries. When the state came back to the market in November, the spread had come down to 300bp, but the yield was still slightly higher.

Clearly this deal isn’t going to win any awards — it had to be shrunk from $4.5 billion to $4.14 billion; it priced significantly higher than the banks had led California to expect; and it soured the entire national market for municipal bonds. You can see how bond investors are unhappy with it. And you can also see how an open auction of $4.5 billion in bonds would have been an utter disaster, since there simply wasn’t that kind of demand in the market.

The article jumps around a lot, and it’s hard to follow the various threads, but I get the impression that the main criticism of the deal is that the banks persuaded California treasurer Bill Lockyer to sign on to a monster bond issue on the grounds that they could build a lot of buzz around a super-jumbo deal and that it would be a blowout success. The implication is that Lockyer — and the muni market as a whole — would have been much better off just saying no.

There might be something to that — but at the same time the bond market had to turn at some point: interest rates never fall forever. And the less that California issued at those low rates, the more of a backlog it would have, and the more it would end up having to issue at higher rates.

I do wonder, though, whether the tremors from this inelegant deal foreshadowed the minor panic that surrounded the Dubai default the following month. California is too big to fail, and there’s an easy carry-trade/moral-hazard play there for anybody who wants it: buy California munis at 325bp over Treasuries, safe in the knowledge that if push comes to shove the federal government will ultimately bail the state, and its bondholders, out. Except the market obviously doesn’t put that much stock in the moral-hazard play, since 325bp is an impossibly wide spread for an entity with a de facto sovereign guarantee. So when Dubai’s sub-sovereign issuers started defaulting, you can see how various pent-up fears might have been let loose.

And therein the biggest lesson of the California deal, I think — one which Marois doesn’t explore at all. What’s California’s credit really like? What are the chances that it will get bailed out by the federal government? And what does that mean for sub-sovereign issuers across the nation and the world? Maybe we’re beginning to see some real differentiation between different levels of credit, depending on whether the issuers are sovereign nations, or states, or state-owned companies, or para-statal organizations, or whatever. And maybe that, in turn, is happening because the sovereigns themselves are running out of money to bail out their subsidiaries.

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