Bankrupt Cities, Muni failures, and CDS stress

Earlier commentary (see Will State SIV Funds bankrupt local communities?) discussed the stress that rising retirement costs, increasing payroll, and poor investments were placing on local governments. Recent headlines demonstrate this trend including the California city mulls filing for bankruptcy press and similar commentary from communities in Florida. ‘"As of April, we will not have the money to pay employees," Vallejo Councilwoman Stephanie Gomes said in a telephone interview. "It's just projected to get worse and worse.’ This situation is likely to become commonplace in 2008.

Many of these local governments have outstanding municipal bonds. In December the outlook for the muni bond market was discussed (see The Muni Bond dilemma). While a number of financial industry pundits claimed that the muni-bond sector would recover in 2008; the unfortunate reality is that the outlook over the upcoming months is bleak.

The failure in the past two weeks of the muni auction rate market simply underlines the calamity. Morgan Stanley announced the failure to auction the preferred shares for its closed end funds. Many other financial institutions were in a similar position this past week. This will all circle around as higher interest rates for communities as local governments are forced to pay default penalty rates on their muni bonds leading to further financial stress.

Adding to the credit concerns, Bill Gross of Pimco outlined this week that the CDS market is a huge systemic risk. "The conduits that hold CDS contracts are, in effect, non-regulated banks," says Mr Gross. "[There are] no requirements to hold reserves against a significant 'black swan' run that might break them." There is significant risk that counter parties will not be able to pay their obligations if the system breaks down, and the cracks are starting to show. The term “default shock” in now regularly used when discussing this $45 trillion market. ‘Credit default swaps are bigger than the US government bond and housing markets combined.’ Many skeptics view that this non-liquid market is primed for disaster as bond defaults approach historical means with minimum losses of $250 billion expected over the upcoming year.

The credit crisis has clearly spread beyond subprime; the contagion to muni-bonds, commercial CDS, and other sectors is not welcome news for investors. Systemic failure in any of these markets is likely to take down retirement plans and other major institutional holders leaving main street America effectively holding the bag. Investors should take a close look at their fixed rate investments and carefully evaluate their risk of structural failure. Common investments such as fixed rate annuities and other vehicles often hold CDS and other at risk instruments.

Similarly this is a time to cast a wary eye on the Muni Bond market despite the hype from firms that focus on selling these instruments. Investors should avoid pouring new money into muni bond funds or directly purchasing these bonds. Yield-focused investors should be concerned with the structural problems in the auction rate muni market, the failure of insurers, and local government fallout. These problems need to be resolved before the muni sector can be considered safe or viable.