Golden muni derivatives

April 28, 2011

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.

She reports:

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.

Fighting words!

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”?

Stay tuned.

** California “quick facts” from the US Census Bureau


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With supplies of new municipal bonds running well below forecasts for this year, California’s return to the market in the second half of the year could exert quite an impact.

Ronald Schwartz, a managing director for StableRiver Capital Management in Orlando, told Reuters in an interview: “When they finally do come back, it might be a tremendous volume and just overwhelm the market.”

California, whose lawmakers are still struggling to reach a budget agreement with Democratic Governor Jerry Brown, plans to save money by delaying general obligation sales until after the start of a new fiscal year on July 1.

If the pause in general obligation sales continues until a possible $5.76 billion offering this autumn, it would be the first time California has not sold general obligations in the Spring since at least 1988, according to the state Treasury. 8/us-markets-municipals-idUSTRE73R6UV201 10428

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April 29 (Bloomberg) — Goldman Sachs Group Inc., JPMorgan Chase & Co. and 14 other investment banks face a European Union antitrust probe into credit-default swaps for companies and sovereign debt.

The European Commission said today it opened two antitrust probes. It will check whether 16 bank dealers colluded by giving market information to Markit, a financial information provider.

JPMorgan, Bank of America Corp., Barclays Plc, BNP Paribas SA, Citigroup Inc., Commerzbank AG, Credit Suisse Group AG, Deutsche Bank AG, Goldman Sachs, HSBC Holdings Plc, Morgan Stanley, Royal Bank of Scotland Group Plc, UBS AG, Wells Fargo & Co., Credit Agricole SA and Societe Generale SA will be investigated for possible collusion in giving “most of the pricing, indices and other essential daily data only to Markit.” 20601087&sid=aV268t_3RCf0&pos=1

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