Muniland “dumb money”

By Cate Long
April 11, 2011


There has been a lot of speculation about the intensity of municipal mutual fund outflows. Investors have headed for the exit for the last 21 weeks. Does this exodus give us an accurate read on the health of the municipal securities market?

Two charts. Two views.

One is the “dumb money” view and the other is the “smart money” view. [No disrespect to anyone reading this blog.]

On Wall Street retail investors and small pension funds are known as “dumb money”. This is because these investors have less knowledge of the practices of the securities markets and less access to sophisticated information. Mutual funds are usually considered products for “dumb money”.

The Lipper data in the chart above shows the exodus from muni mutual funds has slowed and leveled off.  This is a big positive for those who own muni mutual funds. It is also a positive for those who own muni securities directly because fund sales were depressing prices for everyone.

“Smart money” are those in the financial markets who understand how the game is really played and know that the appearance of things is unlikely to represent the true state of the markets. Think Goldman Sachs, or another dealer, selling collaterized debt obligations (CDOs) full of securities they knew would fail then shorting the CDOs. Unfortunately this sort of thing happens more than we know. “Smart money” also has access to much richer, faster, and deeper information about markets. Having an information edge is how profits are made.

Our second chart comes from the “smart money” side. It was provided by Markit and shows the performance of the index for municipal bond credit default swaps (MCDX). We’ll leave for another day how the MCDX is structured but it’s a “smart money” proxy for the health of the municipal market.

Markit_mcdx_4_8_11 Both charts tell the same story. As the MCDX declines it means “smart money” believes that there is less risk of default for municipal bonds. It appears that the MCDX improved ahead of the muni mutual fund flows.

Maybe the Markit MCDX could be a leading indicator for muni fund flows. Let’s watch it a while and see if we can find correlation.

Maybe “dumb money” could learn from “smart money”.  Sounds like a good plan to me.

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Some investment banks took the CDS approach a step further. In 2006, a consortium of investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which created five indices that tracked the aggregate performance of a basket of 20 designated
subprime RMBS securitizations.

Borrowing from longstanding practice in commodities
markets, investors could buy and sell contracts linked to the value of one of the ABX indices. Each contract consisted of a credit default swap agreement in which the parties could essentially wager on the rise or fall of the index value.

According to a Goldman Sachs employee, the ABX Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS securities would lose value.

Page 35 ing/2011/PSI_WallStreetCrisis_041311.pdf

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