16 February 2008 – The Aleph Blog

In Some Ways, The Municipal Bond Market Was Asking For It

Posted on 16 February 200817 February 2008 by David Merkel

What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.

What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.

Now, many of the same difficulties apply to auction rate bonds (another article from Accrued Interest), no matter who the obligor (entity that must pay on the bond) is. As I commented recently:

Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.

Yes, the explanations are all there in the documents, but a good advisor explains things in layman?s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.

Or, as I commented at RealMoney:

		David Merkel
		Failed Muni Auctions are not the End of the World
		2/14/2008 2:50 PM EST

Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?

1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.

The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.

Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.

Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.

Pushing on a String? Credit Marches to its Own Drummer.

Posted on 16 February 200817 February 2008 by David Merkel

Thanks to Naked Capitalism for pointing out this post by Paul Krugman. Here was my response:

Mr. Krugman, do your homework. Extend the graph out to five years, and you will see that yields on Baa bonds fluctuated between 7.1% and 5.7% over that time period. The correlation between Fed funds and Moody’s Baa series was pretty small during that time period, whether the fed funds rate was rising or falling. I just calculated the R-squared on the regression — 0.1%, for a 3.2% correlation.

Maybe it’s just a bad time period, so I ran it back to 1971, which was as far as my Bloomberg terminal would let me go. (Maybe I’ll go to FRED and download longer series, and use Excel, but I don’t think the result will be much different — the R-squared was 6.5%, for a correlation coefficient of 25.5%. Not a close relationship in my book for two time series relationships that are both interest rates.

Practical economists like me are aware that credit-sensitive investments often have little practical relationship to Fed funds. We work in the trenches of the bond market, not the isolation of academic economics, where you don’t contaminate your theories with data.

The Fed may or may not be pushing on a string, but you have certainly not proven your case.

-=-=-=-=-

Here’s the graph for the Fed funds rate and Moody’s Baa yield series since 1971. (When I ran my calculations, I used monthly, but could only get the graph back to 1971 if I went to quarterly.

(graph: Bloomberg)

As I said, not much of a correlation, but why so low?? This is related to a topic on which Bill Rempel has asked me for an article.? (To do that article, I have to drag a lot of yield data off of Bloomberg for analysis; I will be getting my full subscription soon, and once that happens, I can start.)

As an investment actuary, I’ve had to develop models of the full? maturity/credit yield curve — maturities from 3 months to 30 years (usually about 10 points) and credit from Treasuries, Agencies and Swaps to Corporates, AAA to Single-B.? A Treasury yield curve at any point in time can be fairly expressed by a four factor model, and the R-squared is usually around 99%.? (I learned this in 1991, and there is a funny story around how I learned this, involving a younger David and a Bear Stearns managing director.)

The short end of the Treasury yield curve is usually far more volatile than the long end in yield terms (but not in price terms!).? All short high-quality rates are tightly correlated, and that includes Fed funds, Agency discount notes, T-bills, LIBOR (well, usually), A-1/P-1 commercial paper, etc.? As one goes further down the yield curve in maturity, the correlations weaken, but still remain pretty tight among bonds rated single-A or better.? (As a further note, Fed funds and 30-year Treasury yields also don’t correlate well.)

Credit is its own factor, which varies with expectations of the economy’s future prospects.? A single-B, or CCC borrower can only repay with ease if the economy does well.? If prospects are looking worse, no matter what the Fed does to short high-quality rates, junk grade securities will tend to rise in yield.? Marginal investment grade securities (BBB/Baa) will tread water, and short high-quality bond yields will correlate well with Fed funds.

When I say “credit is its own factor,” what I am saying is that outside of Treasury securities, every credit instrument participates to varying degrees in exposure to the future prospects of the economy.? (Credit in its purest form behaves like equity returns.)? For conservatively capitalized enterprises with high quality balance sheets, their credit spreads don’t change much as prospects change for the economy.? For entities with low quality balance sheets, their spreads change a lot as prospects change for the economy.

So, for two reasons, Mr. Krugman should not have expected the Fed funds target rate and the Moody’s Baa yield to correlate well:

Fed funds is a short rate, and Moody’s Baa is relatively long (bonds go over the full maturity spectrum).
Fed funds correlates well with the highest quality yields, and Baa is only marginally investment grade.? Recessions should hurt Baa spreads, leaving yields relatively constant.

Let the Lawsuits Begin — II

Posted on 16 February 2008 by David Merkel

Consider this article from the WSJ, Bond Insurer Seeks to Split Itself, Roiling Some Banks.? The banks will fight this.? Here are some quotes:

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.

and —

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a “bizarre situation.”

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC’s move could result in “instant litigation.” FGIC didn’t respond to queries about the banks’ reaction to Friday’s announcement.

?now, it could lead to:

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

and —

However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn’t clear how those “credit default swaps” would be valued, since one half of the new company would have a higher risk of default than the other.

?To the extent that the NY Department of Insurance limits the legal liability of PMI, they raise their own liability.? If I were one of the banks, I would sue the State of New York, and quickly, because NY is moving more quickly than they ought to.? There is no NY crisis here, and the politicians and bureaucrats of New York should behave as gentlemen, and not thugs.

Now, one thing I would agree with the NY Department of Insurance on is this: no dividends to the holding companies.? Until things stabilize, retain assets at the operating companies in order to make sure that claims can be paid.? If MBIA and PMI go broke, that is no great loss, except to those that hold equities, or holding company debt.? But if the operating subsidiaries go broke, that is significant to those who will make claims against the companies.