Markets hold the whip, but are they rational?

There has been a lot of discussion over the past few days about whether the United States deserves a triple-A rating. The weak and meandering attempts of the Congressional leadership and President Obama to reach a consensus on raising the debt ceiling has prompted this storm of confusion. The political theater is painful.

Most of the talk about ratings revolves around whether the level should be lowered one or more notches. But in The Telegraph today Ambrose Evans-Pritchard goes further and says it’s not really that important whether the United States retains a triple-A because the credit rating agencies don’t have the credibility to strip the rating to the world’s largest sovereign debt issuer (emphasis mine):

Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.

Evans-Pritchard’s statement implies that the qualitative judgments of rating agencies about default risk are less useful than the collective insight of bond-market participants. But is the market rational? The bond markets assess their view of the likelihood of default through a quantitative measures like credit-default swaps.  CDS are bought and sold between institutional investors and represent a sort of wager on whether an issuer like the United States or the state of Illinois will default on its bonds. They are a kind of insurance policy because if the issuer does default then the holder of the CDS receives payment of principal from the issuer. In other words, it’s an opinion with a whip in its hand — unlike the assessments of credit rating agencies, whose raters suffer nothing if they assigned the wrong rating.

The CDS market data provider, Markit, sent over some price levels on municipal CDS today that included a price for CDS on U.S. Treasuries. I thought it might be interesting to compare the credit rating of the US (AAA/Aaa) and the corresponding credit-default swaps (in basis points) against some heavily indebted states (see chart above).

Green shoots?

Green shoots?

Reuters reports on recent data from the U.S. Census Bureau that shows how tax revenues are improving:

State and local governments brought in record first-quarter revenues this year, according to a Census Bureau report released on Tuesday that offered a sign their budget crises may be abating.

Total state and local revenues for the first quarter reached $321 billion, a 4.7 percent rise from the first quarter of 2010 and the highest level on records going back to 1988. It marked “the sixth consecutive quarter of positive year-over-year growth,” the Census said.

Muni swaps moving higher

Lisa Pollack of Markit in London sent over some interesting charts of U.S. municipal swaps. I put up this one which shows the market perception that risk is increasing again for some states, particularly Illinois and California. It is important to remember that these markets are thinly traded and that there is a large block of muni CDS written on California that is coming to market from the bankruptcy of Lehman Brothers.

National Totals of State Tax Revenue, by Type of Tax

The U.S. Census brings us these figures for taxes collected at the state level for 2010. You can see the substantial reliance on individual income and sales taxes (I left off some categories to fit the table in. Click through to the Census document to see more data): Quarter Total tax Individual income Corporate income Property tax State sales tax 2010 4Q $ 177B $ 61B $ 9B $ 4B $ 57B 2010 3Q $ 168B $ 57B $ 7B $ 3B $ 56B 2010 2Q $ 204B $ 72B $ 14B $ 3B $ 54B 2010 1Q $ 163B $ 52B $ 8B $ 8B $ 54B


Muni sweeps: Lockyer rides again

CA Treasurer launches another derivatives investigation

We often see Wall Street selling sophisticated products to state and local governments which are not appropriate for them — think interest rate swaps and Jefferson County. So it’s always refreshing to find a government official who actually tries to keep Wall Street in line.

Sharp-eyed California State Treasurer Bill Lockyer has been monitoring the spread (price) levels for the state’s credit-default swaps. He noticed a very significant one-day drop in CMA Datavision (one of two muni CDS price aggregators) and wants to understand what caused this. Katy Burne at Dow Jones has done an excellent job reporting the story:

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.

Muni sweeps: Derivatives transparency for dummies


The colorful chart above is from Lisa Pollock of Markit and shows the states which have the most traded credit-default swaps and their spreads to the benchmark. Bloomberg has more on that theme.

Derivatives transparency for dummies

Much of the damage that occurred in the financial crisis of 2007-09 came through the use of derivatives. Wall Street sold these products to sophisticated and unsophisticated investors across the globe. I wrote about the efforts of the Pennsylvania Auditor General Jack Wagner to develop a database of swaps for local governments. This effort should be lauded and hopefully copied by other states. But the value of the information in the database is not as great as having near real-time trade information to compare the pricing of a new derivative.

The Dodd-Frank Act has authorized a lot of transparency for the derivatives market. It’s very complex and arcane, so don’t worry if you haven’t figured it out yet. The law firm Reed Smith has created a “derivatives transparency for dummies” chart and I thought it would help us understand the changes.

Muni Sweeps: Muni CDS

Lisa Pollack of Markit in London posted via Twitpic this table of DTCC data on municipal credit default swaps. Since California is the biggest muniland issuer it’s not a big surprise that it leads with the greatest number of contracts outstanding.

The market is cleaved into two pieces

The Municipal Securities Rulemaking Board has issued a critical new rule for muniland. The rule, known as G-23, prohibits a dealer, such as JP Morgan or Goldman Sachs, from advising a municipal entity and then switching hats to act as the underwriter. Do you see the massive conflict that this could have posed?

The dealer, acting as an “adviser,” could have set up the municipality to structure a bond that had more expensive fees than a straight bond, and then jump over to being the underwriter to collect the higher underwriting fee. If a dealer is acting in a dual role, who is looking out for the issuer’s interest? Previously the dealer was only required to make a disclosure that the dual role could be a conflict.

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.

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.

Muni sweeps: Strutting her stuff

Philly mummers 2009

She may not be the prettiest girl but at least she’s out there

The home of the famous Mummer’s parade struts its stuff for the bond markets.

The city of Philadelphia was named tops for transparency in a University of Illinois at Chicago survey of cities providing investors with financial information online.

Every municipality, like every person, has problems. Hiding them doesn’t instill confidence in investors. I’m glad to see Philly and other cities letting it all hang out. From the the Philadelphia Inquirer:

Muni sweeps: Christie’s battles are not credit positive

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We are a nation of states with differing political cultures and leaders.  Loud leaders and quiet leaders.

The loud ones get most of the attention. Do financial markets reward the loud ones too?  Not always it seems.

New Jersey Governor Chris Christie gets a lot of attention for his approach to governing. And has garnered a lot of political interest for his full-on attack on his state’s municipal unions. See the video above for an example.

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