Examining muniland’s indices after the Libor scandal

The muni market’s overseer, the Municipal Securities Rulemaking Board (MSRB), is taking aggressive action to survey muniland indices following the Libor scandal. The board is asking index providers to disclose more about how certain indices are developed. The MSRB has no direct authority to regulate indices because, as with Libor, they are maintained by private companies and are outside of the board’s legislative mandate to regulate dealers. Alan Polsky, the current chairman of the MSRB, said in a press call that the board did not believe that there was any wrongdoing in this corner of the market, but that increasing transparency would enhance investor confidence. Here’s what he stated in a press release:

“Like other regulators, the MSRB is concerned about the transparency surrounding the development of market indices,” said MSRB Chair Alan Polsky. “We plan to review indices used by the municipal market – and develop educational materials about their use – to ensure that the market operates fairly and transparently.”

This is exceptionally good news because the municipal markets generally lag behind the equity markets in the transparency of their indices. You could easily calculate the value of the Dow Jones industrial average yourself, because information on all of the Dow’s components are publicly available. The same can’t be said for the Bond Buyer 20 index.

Here are some of the widely used indices in muniland:

The indices about which we know perhaps the least, though, are tied to Markit’s municipal credit default swaps. They describe their CDS pricing process generally like this:

Markit receives contributed CDS data from market makers from their official books and records. This data then undergoes a rigorous cleaning process where we test for stale, flat curves, outliers and inconsistent data. If a contribution fails any one of these tests, we discard it. By insisting on the highest standards, we ensure superior data quality for an accurate mark-to-market and market surveillance.

Muni CDS goes ‘bang’

The use of credit default swaps in muniland is poised to take off, a project that’s being called the “U.S. Municipal CDS Bang.” Starting Apr. 3, the terms and conditions of new muni CDS have been standardized with the stated intent of creating a useful risk-hedging product. This project is being driven not by regulators but by Markit, a private market-data vendor, and the International Swaps and Derivatives Association, a global consortium of Wall Street banks. But it’s not so clear that this is what the market needs at this time.

Although the muni CDS market is unregulated, the SEC is set to implement new rules (§§763 and 766) in the second half of 2012, according to the schedule posted at the agency. Even that may be optimistic, as a lot of the SEC’s deadlines for Dodd-Frank rule-writing have slipped. Nevertheless, it’s curious that these changes to muni CDS contracts are being introduced ahead of the SEC’s rules. In most instances, banks and dealers wait until the regulatory framework has been established before rolling out new products, which is what happened with the Volcker Rule.

Municipal CDS do not trade publicly, nor do they have publicly available pre-trade or post-trade information. All available pricing information for muni CDS comes from Markit, the privately held market-data firm in London. When I asked for details about the firm’s ownership, Markit was unable to provide them. Instead, the firm referred me to Companies House, the UK equivalent of the SEC’s Edgar filing service. From their required filings at Companies House, I discovered that the banks that provide the pricing information for muni CDS are mostly the same banks that sit on the Markit Board of Directors and the Determinations Committee of ISDA, the organization that decides if an event that occurs in the underlying reference bond should trigger a payout of the CDS.

There is no municipal CDS market

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.

Reading the muni CDS tea leaves

I saw a strange tweet this morning that said “State CDS blew out yesterday per Bloomberg. Not sure what I missed here.” The anonymous tweeter attached the image above of graphs of credit-default swaps for 9 big states. Notice the very sharp one-day spike for every state except Ohio. Those spikes mean that those who trade muni CDS suddenly thought U.S. states were riskier, by anywhere from 2.09 percent to 17.02 percent, in one day. That is a big gap up.

Municipal CDS reference the equivalent cash bonds of the obligor. So a NY10Yr CDS references New York State general obligation bonds that mature in 10 years. CDS and cash bonds use different units of measurement but generally move proportionally to each other. So if investors no longer want New York State general obligation bonds and their price declines, one would usually see the CDS sell off too.

But municipal cash bond markets didn’t sell off yesterday. You can see in the Thomson Reuters Municipal Market Data chart below that New York State general obligations have been trading pretty steady recently. There certainly wasn’t a 17 percent drop yesterday like there was in the NY10Yr muni CDS. What’s going here?

Crawling in the dark through the muni CDS market

I’m beginning to think that Europe’s sovereign debt crisis might kill more than municipal credit default swaps. As the financial system trembles alongside the deliberations of the Greek government, areas of the markets that have quietly lumbered along in the dark are getting more and more attention.

Bloomberg held an excellent state and local finance conference on Wednesday where there was a brilliant session with the state treasurers of North Carolina, Delaware and New Jersey. Bloomberg Editor-in-Chief Matt Winkler grilled the trio on the use of derivatives, mainly interest rate swaps, by public officials. In the most thought-provoking back-and-forth, Winkler asked what the difference was between Alabama’s Jeffereson County and Greece. Both Greece and Jefferson County have extensive ties to financial institutions through the bonds they issued and derivatives they have either entered into or that have been written on them. In the case of Jefferson County this exposure is mainly concentrated with JP Morgan Chase, the lead underwriter for most of the bonds and derivatives written on the county. In the case of Greece it’s fairly well-known who owns its bonds but it’s practically unknown how deep the interconnections are for derivatives. As Bloomberg wrote:

The European nations are linked in a network of debts, as Bill Marsh recently illustrated in the New York Times with a beautiful piece of graphic art. The image is like a complex wiring diagram for a ticking debt bomb. Yet what it shows may be less important than what it leaves out: a largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.

Let Europe kill municipal CDS

The solution to Greece’s debt crisis that Europe’s leaders announced on Thursday has market participants and commentators howling. It includes a provision that changes long-established rules for credit-default swaps mid-game. Mike Dolan, Reuters’ Investment Strategy Editor in Europe, said this:

For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies.

I’d suggest that death knell just rang for U.S. municipal credit-default swaps (CDS), too. They’ve recently been on their last legs amid collapsing volumes, but actions in Europe just might have delivered the deathblow.

The weakest states are stronger than U.S. banks

The weakest states are stronger than US banks

I noticed something very interesting in some research that Markit, a data provider that tracks the credit-default swap market, released yesterday: the worst U.S. municipal credits (California, Illinois and New Jersey) are considered much stronger than all the major U.S. banks save JP Morgan. New York state is considered stronger than Mr. Dimon’s bank!

Why this is especially important in muniland is that these U.S. banks write a lot of credit-default swaps insuring the debt of these large states, which seems upside-down given that credit markets view the banks as weaker than the states they insure. This raises questions about the validity of the whole muni CDS market. I’ll dig around on this issue a little more.

Heavy political support for ending municipal-bond tax exemption

Bloomberg writes about several strong political forces in favor of ending the tax exclusion from municipal bond interest payments. I still haven’t seen a definitive cost analysis of the change though. Maybe the President’s proposal to reduce the tax exclusion on muni bonds for those earning over $200,000 is a signal to Republicans that the administration is willing to negotiate the issue. From Bloomberg:

Does a downgrade cost anything?

The debt of the United States was downgraded by Standard & Poor’s several weeks ago, but the price of U.S. Treasuries have skyrocketed since then. This confuses many people because a baseline relationship in the fixed-income markets is that lower-rated, less-creditworthy bonds will be relatively cheap and investors will demand higher interest rates to compensate for additional risk.

To see this bond market truism, it’s much more instructive to look at the downgrade of the debt of New Jersey. Fitch lowered the state’s credit rating Wednesday citing heavy debt and benefit obligations. This followed downgrades by Moody’s and S&P earlier in the year. Municipal bond and credit default swap markets didn’t like this third downgrade and did what you would expect them to do: they required more yield in the case of cash bonds and more payment in the case of credit default swaps.

The graph above charts muni CDS prices for New Jersey (data supplied by Markit). You can see the move up in CDS prices began in June when Governor Christie and the state legislature made the final run to their agreement on the fiscal 2011 budget, which began on July 1. The uncertainty and contentiousness of the process must have spooked investors and dealers.

The swirl of ratings and CDS

The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.

The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.

The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.

Regulator wants to require “fair dealing”

Regulator wants to require fair dealing

In a far-reaching proposal, the Municipal Securities Rulemaking Board (MSRB) has asked the Securities and Exchange Commission for permission to impose new rules to protect municipalities. These rules would vastly expand the disclosures that dealer underwriters are required to give their municipal clients who issue bonds.

MSRB’s executive director Lynnette Kelly Hotchkiss said in a statement:

Dodd-Frank explicitly requires the MSRB to protect municipal entities. This gives us the ability to establish detailed requirements for underwriters and make important information more readily available to state and local governments that sell bonds.

The rules would require disclosure of “conflicts of interest” to municipalities before they enter into contracts to issue bonds. Specifically the new rules would require banks to:

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