Muniland’s black swans
Are we looking in the wrong places?
John Carney of CNBCÂ arguesÂ for the possibility of a black swan event for muniland.
He’s right about unknown risks but I think he is looking in the wrong place.
He doesn’t mention municipal derivatives in his analysis. I mean interest rate swaps not municipal credit default swaps.
Derivatives are likely to be where muniland’s biggest risks lie.
From John’s blog NetNet:
Many muni bond professionals believe that fears of a massive wave of defaults are â€śoverblownâ€ťâ€”and they look at recent signs of strength as an affirmation of their view.
Unfortunately, many of those who insist on the strength of the muni market seem to be blind to the vulnerabilities of muni bonds.
Although they never actually admit this, the muni bulls are insisting that municipal debt is exposed only to normal, predictable risksâ€”and not unpredictable, wild risks. To put it in the terms of Nassim Taleb, they are claiming that all muni market swans are whiteâ€”because theyâ€™ve only encountered white swans in that market before.
The biggest muniland derivatives problem to date (after the auction rate securities blow-up) has been the struggle in Â Jefferson County, Alabama which is still not resolved.
From a November, 2009 SEC announcement:
J.P. Morgan Securities settled the SEC’s charges and will pay a penalty of $25 million, make a payment of $50 million to Jefferson County, and forfeit more than $647 million in claimed termination fees.
The SEC alleges that J.P. Morgan Securities and former managing directors Charles LeCroy and Douglas MacFaddin made more than $8 million in undisclosed payments to close friends of certain Jefferson County commissioners. The friends owned or worked at local broker-dealer firms that performed no known services on the transactions. In connection with the payments, the county commissioners voted to select J.P. Morgan Securities as managing underwriter of the bond offerings and its affiliated bank as swap provider for the transactions.
Recently Denver public schools issued new debt which included $50 million to terminate a swap agreement made with JPMorgan in April 2008 and $12.1 million for termination payments in connection with a swap from 2005. In the article Bloomberg reporters Darrell Preston and Brendan McGrail claim this derivatives settlement is three times the annual cost for food in the Denver public school system. Starting to get a sense of the black swan?
Then there is the collusion between JP Morgan, Bank of America and up to 10 other banks with CDR Financial Products in which guilty pleas began coming inÂ Â February, 2010. Basically the banks were rigging their bids for providingÂ guaranteedÂ investmentÂ contracts (GICs)Â to municipalities. (Sounds like the currentÂ controversyÂ over LIBOR!)
The problem of muni derivativesÂ first surfaced in 2008 when Bloomberg started reporting on 500 deals totaling $12 billion done in Pennsylvania between 2004 and 2008. If Pennsylvania had this many deals it’s easy to imagine this cancer all across America.
When Jamie Dimon, Chairman of JP Morgan, recently sided with Meredith Whitney on predicting a large number of muni defaults I wondered what information he had that varied from the credit rating agencies. After reflecting on this for awhile it seemed so obvious. JP Morgan is one of the largest municipal underwriters and has also been at the center of so many municipal messes. Was Mr. Dimon signaling the trouble to come for muniland?
Unfortunately there is no central repository of municipal derivatives. And I rarely, if ever, see it mentioned in muni trade associations.
I think America’s black swan is municipalÂ derivatives. Let’s keep our eyes peeled.