Golden muni derivatives
Is the “Golden State” golden?
Some banks and hedge funds don’t think California is so golden after all. And they have bought credit default swaps insuring (or betting) against it’s default.
We know about these muni derivatives because of some excellent reporting from Katy Burne at Dow Jones.
The banks disclosed the trades to California Treasurer Bill Lockyer last month in response to his request that all 86 of the state’s bond underwriters detail the volume of credit default swaps they traded on the state’s roughly $80 billion of general obligation bonds in the three months ending Jan. 31.
Since the municipal CDS market is relatively illiquid, the act of buying default protection can send the cost of that protection higher, sometimes pushing up borrowing costs for the relevant issuer.
“We believe it’s wise, and in taxpayers’ best interests, to continue monitoring the California CDS trading activities of our underwriter pool members,” said Tom Dresslar, a spokesman in Lockyer’s office. “We reserve the right to take those trading activities into account when making decisions about membership in the pool and when selecting book runners.”
California Treasurer Bill Lockyer has been on this pony before. Here is what he wrote to Goldman Sach’s Chairman Lloyd Blankfein last year:
“I write to request information about your firm’s market activities related to credit default swaps on municipal bonds in general, and State of California general obligation (GO) bonds specifically.
The State never has defaulted on a debt service payment in its history. Small wonder.
The Governor’s revised 2009/10 budget projects General Fund revenues at $88 billion and schools spending at $41 billion.
General obligation [GO] debt service has first call on the remaining $46 billion.
GO debt service for FY 2009/10 is projected at $5.2 billion.
In other words, we have debt service coverage of more than 8 times.
Data reported in the news media and other sources show that the prices, or spreads, on California CDS wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan, Croatia, Bulgaria and Thailand.
The perception of risk could adversely affect the price of our bonds when we go to market. That makes the CDS market important to our taxpayers.
That is why I want to fully understand the municipal CDS market in general, the market for California CDS, and your firm’s role in these markets.
I read today that the combined CA debt load and unfunded pension liability is approximately $3,700 per capita. Or $14,800 for a household of four. The need to pay off this debt stretches over many, many years. My rough estimate is over 15 years.
Here are the amounts per bank of credit fault swaps reported to California Treasurer Lockyer:
- Goldman Sachs – $4.3 billion
- Morgan Stanley – $2.5 billion
- Barclays – $2.5 billion
- Citigroup – $1.9 billion
- JP Morgan – $1.5 billion
- Bank of America Merrill Lynch – $1.9 billion
All banks are reporting amounts in gross notional outstanding. And no other banks reported writing credit default swaps on California debt that were underwriters of CA debt.
The Bond Buyer reported on the banks’ customers for California CDS:
The banks listed commercial banks, broker-dealers, hedge funds and insurers, including monoline bond insurers, as participants in the California CDS market.
Goldman Sachs chief executive officer Lloyd Blankfein said 63% of his firm’s California CDS trade volume came from banks or broker-dealers and 31% from hedge funds. Money managers and insurers together accounted for just 5% of the volume.
The State of Califionia is rated A1/A‐/A‐ by the three major rating agencies. These are mid level investment grade ratings.
So what is going on with these banks writing ~ $14 billion of credit default swaps on the “Golden State”?