Disclosure - My advisory firm is short PMF and PCK, two ETF's that invest in Muni bonds and short AGO, a stock company with significant Municipal Bond exposure. The portfolios that have short exposure to these securities stand to profit if the price of these securities fall. The positions in PMF and PCK have been held for longer than five months and AGO has been a trading position that was first entered into over five months ago.
PART I: MUNICIPAL BOND PERFORMANCE
Over the past few weeks, several ETF's invested in Municipal Bonds have collapsed in price. The funds I track are PMF, NUV, MYI, VGM and PCK. The following table illustrates their price returns since they peaked on 8/31/10 and started to crash since 10/31/10 until the close on 11/18/10:
|Ticker||Since 8/31/10||Since 10/31/10|
The odd thing is that I virtually cannot find any mention of this seemingly significant fall in prices in the financial media, on investing websites or amongst other analysts that I communicate with. It has been a stealth correction. Surprisingly, it seems no one is wondering why Muni's have performed so poorly in the past few months. Conversely, I am asking, "Why have Muni's performed so well in the past few years?"
While news from what I call The FAKES [Florida, Arizona, Kalifornia, the new Englands (NJ and NY) and Springfield, IL] has repeatedly told the market that trouble is brewing, the markets seem deaf to the news - at least until now.
PART II: SIMILARITIES BETWEEN MUNI'S AND CMO'S
When I study the Muni bond market, I cannot help but notice the similarities that exist between it and the CMO/CDO market prior to 2008. The following are a few of the larger issues that Muni's share with the CDO's of markets past.
Illiquid: I don't have much experience with trading Muni's but the last one I sold took three months. It traded for an hour a day on the third Wednesday of the month. The first month, I put in a limit order that wasn't filled, the second month I was on an appointment and couldn't be at my computer when it traded and in the third month it was filled at the bid, several points below the ask.
There is not a terribly liquid market for Muni bonds. The institutional investors who are most likely to buy the bonds typically do so directly from the dealer and then hold them to maturity. The secondary market for Muni bonds I am sure is far more liquid and efficient than the CDO market was but not nearly as liquid as Corporates and Treasuries.
Leveraged: In order to juice the yield on low-yielding bonds, many managers leverage up positions. As long as prices go up or move sideways, this is a wonderful way to squeeze returns out of securities deemed to be safe. However, in 2007 a couple of Bear Sterns funds collapsed and the world learned just how ill-advised this strategy can be when prices fall. Or at least I had thought that we had learned this lesson but apparently not. Today, money managers are pulling the same tricks with Treasuries, Muni's and other bonds that they pulled with CDO's in the earlier part of this decade.
Because the market is so illiquid and bonds don't trade regularly, managers do not have to accept write downs on their portfolio. You can't mark-to-market when there is no market. But when they are forced to sell their positions and there is no bid, they end up being squeezed in the other direction.
Woefully Inadequate Insurance: In 2008, the market discovered that Credit Default Swaps (CDSs) on CDO's, derivative contracts designed to insure against a default on a CDO, were woefully inadequate. The problem was that the writer of the insurance contract, the CDS, did not have to provide reserves against the position. Without reserves, insurance isn't exactly insurance.
While many Muni's are insured by companies like Assured Guaranty (AGO) who do have reserves, the reserves will not be adequate to insure against a systemic default in the Muni space. Insurers never have and never will have the ability to protect agains a systemic loss. The markets learned this the hard way when Ambac and MBIA failed insuring residential mortgages. They could insure against a household defaulting due to job loss or medical bills but they could not insure against a systemic fall in home prices.
The hard truth is that insurance is designed to protect the buyer of the coverage in the case of a one-off, non-systemic event. A house fire, a car wreck, a premature death. Insurance cannot protect against a systemic loss such as widespread black mold in Texas homes or an entire city flooding such as the case was with New Orleans. The muni insurers could insure against a single municipality going under but will not be able to insure against several municipalities defaulting on their debt.
Fundamentally flawed (yet people are still buying them): I won't spend any time outlining the reasons why these bonds are so terribly flawed from a fundamental perspective. If anyone actually believes that the great majority of municipalities can make good on their obligations without federal assistance, I know of some land out in Arizona with a view of the ocean (both of them) which the bank is willing to let go at the unbelievably low price that they booked it at when they marked-it-to-market back in 2006.
What I find curious about Muni's is that people are still buying them even when it is clear that the market is deteriorating. Why? I think the short answer is that everyone assumes the US government will bail out the Muni bond market just like everything else. Why the market is confident in a Fed bailout, I'm not quite as optimistic.
PART III: FOUR REASONS WHY THE FEDERAL RESERVE (FED) AND TREASURY MAY NOT BAIL OUT THE MUNI BOND MARKET.
1. Too big
2. Too Diversified
3. Don't care (enough)
4. Local governments will refuse to accept Bailout
At over $2.7T, the Muni bond market is massive, larger than the capitalization of the banking system that failed in the fall of 2008. Furthermore, the FED is essentially out of bullets. What would Gold and Oil do if the FED announced they were printing enough dollar bills to bailout every municipality that is in trouble? How much more can the FED expand their balance sheet? What sort of moral hazard would be created? (And when we will quit being redundant and using the FED and Moral Hazard in the same sentence - the FED by its very nature is Moral Hazard.) Recently, they resorted to another round of Quantitative Easing to the get the economy going sans another collapse, what could they possibly do in response to a legitimate threat. The FED is tapped out. A crisis the size of a widespread default by The FAKES maybe too much for the Fed to absorb.
Muni Bonds come in all shapes, sizes and colors. There are distinct bonds for every different local government, project, timeframe, ect., ect., ect. How could the FED possibly decide which ones to buy and which ones not to. In 2008, the formula was simple. Bailout Goldman and the Morgans and anyone with significant counterparty risk to Goldman and the Morgans. Otherwise, they let it go. By their own admission, they could not save them all back then and neither will they be able to save all the Muni bonds that are bound for default.
Don't Care (enough):
Most folks agree that the 2008 Emergency Stimulus was nothing more than a banking bailout and had virtually nothing to do with saving America's economy. The banking cartel hoodwinked American and D.C. into thinking that if the banks recovered, the economy would soon follow. Today, we know that to be a lie (back then, I also knew it to be a lie so I wrote my US Senator and I was assured by their office that he would not support the bill, which was also a lie). There are practically a dozen proven methods for solving 2008's problems that would have been better for the economy none of which D.C ever considered because the banking cartel wouldn't allow them.
If The FAKES begin to default, would these same people (Bernanke, Paulson and crew) who fooled us the last time have the same conviction, motive and success in convincing America to save counties, cities, townships and states? The bailout run by the Fed and the Treasury which was headed up by a Goldman Ex and is now headed up by a FED Ex do not care one bit about anyone outside of Wall Street. They don't care if Muni's can raise money. They don't care if teachers and policemen lose their pension. If it is in their best interest to save this market, they will. If it is not, they won't.
Keep in mind that there is very little that is Federal about the Federal Reserve. It is a private bank controlled largely by its membership. The chairman and a few board members are appointed by the President but ultimately the control lies in its member banks.
Local governments will refuse to accept the Bailout:
There are a lot of illnesses where the treatment is worst than the disease. This might be the case with a Muni bond bailout. A lot of local governments may decide that defaulting on its debt would be better than living under the influence of D.C. Already, the states have been stripped of much of their sovereignty, they very well may decide enough is enough. The FED would love the power grab but the local governments, who are also power hungry, will fight to give it to them.
Let's just take a quick look at who we have with the troubled FAKES. In New Jersey, they have a governor who has yet to shy away from "taking the bull by the horns". So far he has not flinched when threatened by anyone. Florida has a fiercely independent governor and a history of electing Republicans to high offices. Both California and New York have the general mentality that they are of greater importance to the national well-being than DC. They view themselves as above the rest and will fight any control from on high. Arizona is deeply Republican and their long-term Senator just lost his Presidential bid to the current administration. A state fighting to keep illegal immigrants out will fight to keep DC out as well. And Illinois is well Illinois. Even if the FED is willing and able to bailout The FAKES, The FAKES may prefer to go it alone which would ultimately mean default as it is in their constituents' best interest.
PART IV: CONCLUSION
Assuming debt is unsecured, when the debt payments an entity are making are greater than the amount of debt being raised (i.e. taking on more debt for the sole purpose of paying off debt) then it makes economic sense to default. Municipalities may find themselves in this precarious position if they are not already there. Why should I as a citizen who has suffered inflation in prices and deflation in financial assets and net worth while Wall Street is paying itself 7 figure bonuses, approve a tax hike or a decrease in services so that my city can keep making interest payments to Wall Street? Sorry, but I don't think it will happen. Philadelphia, Chicago, Orange County, Detroit and Washington D.C., are all prime examples of how local governments will protect their own.
Regardless of what will happen and how it plays out, the markets are telling us something and that something is that there is stress in the Municipal Bond market. Currently, muni bonds are pricing in a strong probability of a FED bailout and this analyst is not sure the odds are that high.