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.

Quick Takes: Student Loan Auction Rate, CDS, and Condo Market

Auction Rate

The most immediate fall-out of the Auction Rate seize up this past week (see More Credit Turmoil: The Muni Auction Rate market freezes) was the student loan market. The failure left North Carolina and many other states scrambling to find new financing. More than two-thirds of our state’s $3.3 billion in student loans were financed using the auctions. It comes as a shock to many parents that the failure of this structured market may mean that no funding will be available to send junior to college this year. This is another example of the poor risk modeling and greed on Wall Street impacting Main Street.

The News and Observer article “Lenders need new financing: Student-loan providers scramble as key credit market fails” provided some very pertinent observations about the situation.

"The whole notion of a failed auction when I started 10 or 11 years ago was unthinkable," Brooks said. "The same could be said three weeks ago. I'm not sure when -- or if -- they are coming back."

The failure has nothing to do with the authority's credit rating or the value of its assets. Both are strong.

"But it speaks directly to people's confidence and trust in the credit markets," said UNC-Charlotte finance professor Tony Plath.

The failed auction stung some agencies harder than others.

The Michigan Higher Education Student Loan Authority announced Tuesday that it would suspend one of its lending programs after the auctions failed.

The auction rate market situation is not likely to improve in the upcoming months. The obvious result is the suspension of many student loan programs across the majority of states as government entities scramble to obtain new funding sources – the crucial problem being that most of these alternative sources will be at higher cost. This will immediately reduce the amount of available loan money and raise the costs for the students.

Credit Default Swaps

A new word for 2007 was subprime, for 2008 is will be Credit Default Swaps as this market implodes in a manner that makes subprime appear to be minor league. At least this is the growing opinion of many economists and media articles. The latest addition was the Arcane Market Is Next to Face Big Credit Test overview from the New York Times on Sunday. The article points out that the unregulated CDS market is enormous at $45.5 trillion in size, double the size of the stock market.

Worst of all the market is crumbling as participants are finding that many of the players will have trouble paying their obligations. As the default rate rises in the bond market, the CDS market will come under increasing pressure. Similar to subprime, a higher level of risk was never really priced into these structured CDS products. This likely sets the table for another credit market fiasco.

Downtown Condo Market

A mere few months ago, the media was hyping the downtown Condo market as resilient in a down real estate market. Outlining the high prices and large numbers of pre-sold units, the industry extrapolated that this trend would continue leading to more projects being planned. Fast forward to today’s business headline “Condo market goes sour: Demand for downtown units falls victim to troubles in home-sales market”

Developers are busy reducing the number of proposed units, cancelling projects, offering incentives, and trying to assist buyers with financing in a tightening credit market. It is starting look like the market for these over-priced units in downtown Raleigh have gone from gold mine to dust bowl.