There is no municipal CDS market

January 12, 2012

California Treasurer Bill Lockyer, who is responsible for issuing new debt for the state, takes a lot of interest in the price of California’s municipal credit default swaps. The price of muni CDS can affect the cost of issuing new debt, since some investors use muni CDS as a pricing benchmark. But new work published by risk-management firm Kamakura suggests that there is no real market for municipal CDS and prices are generated primarily by broker-dealers posting their best estimates. If a specialty market is just a matter of a few dealers privately sending quotes back and forth, is it a real market? I’m not sure that it is.

There was a big story last June about Treasurer Lockyer rooting out some inconsistencies in muni CDS prices. He noticed that there was a sudden drop in the day-to-day price of the CDS used to insure California’s bonds. Katy Burne of Dow Jones reported in June:

California’s state treasurer is looking into what he believes were erroneous prices reported last month for credit-default swaps tied to the state’s debt.

The annual cost of protecting $10 million of California debt against default over the next five years fell by $45,000 from one day to the next last month, an extraordinarily big overnight move. Tom Dresslar, a spokesman for Treasurer Bill Lockyer, said that CMA Datavision provided the prices to Bloomberg’s fixed-income data service.

Lockyer suspects the cost of credit-default swaps, which are expressed as a percentage of the amount of debt covered, was artificially high before the adjustment.

“To the extent our prices are wrong, particularly if they are on the high side, that presents an inaccurate picture of our creditworthiness, at least in some corners,” said Dresslar in an interview Tuesday.

The sharp-eyed treasurer noticed the pricing blip, which could have been either an error — a trader’s attempt to recalibrate the CDS in one shot — or the result of a real sale rather than just best-estimate price quotes. I noticed the same thing for eight states whose muni CDS blew out in December. During that time the muni CDS for New York State leaped 17 percent in one day. This suggests that the market was very thinly traded and when a seller showed up to unload securities, not many were there to buy them. In this case the buyer has a very strong advantage and can force a deep discount to “help out” a panicked seller.

The newly published work of Kamakura confirms that muni CDS markets are very, very thinly traded. In their groundbreaking work Kamakura showed that almost no real trades happen within the municipal CDS markets, and the few trades that do happen are between broker-dealers. Kamakura found:

  • The median number of non-dealer trades per day over the 77-week period among the 9 municipal reference names was 0.06.
  • The highest average number of non-dealer trades per day for the full 77-week period among the 9 municipal reference names was 0.36.

“We find, unfortunately, that (in the words of Gertrude Stein) ‘there is no there there,'” Kamakura says. With a median of only 0.06 of trades per day being done by non-dealers, I would definitely say there is nothing there.

CDS markets trade over-the-counter with no public reporting of trade data. They are the ultimate dark markets. Both CMA Datavision and Markit are private data vendors that receive muni CDS quotes from broker-dealers and aggregate them into published market prices. But what is never known is how much of the price quotes represent real trade executions, versus dealers just throwing quotes out there.

When Treasurer Lockyer is ready to bring one of his state’s gargantuan bond issues to market, he wants to pay the lowest yield possible on the bonds. Given how little real trading is going on in his state’s muni CDS, why should he trust the benchmark at all? It would be very easy for a few dealers to raise his borrowing costs artificially by raising their CDS quotes. And we’ve seen recently in dark muniland markets how these types of things can happen. We need light on this market, or we need it to go away. There is no municipal CDS market, Treasurer Lockyer.

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