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Son of Subprime (the upcoming Muni bond debacle)
dailyreckoning ^ | 08/02/10 | Addison Wiggin

Posted on 12/28/2010 5:30:25 PM PST by dennisw

Son of Subprime


In 2007, the writing was on the wall. The famous “perfect storm” had gathered above the US housing market, its eye hovering over subprime loans. As you know, the storm came…and it rained, and rained, and rained… Ultimately, it washed away trillions of dollars in investor wealth.

Now in an entirely different sector – probably the last place you’d look – the clouds are turning black once again. Strip out the finer details, and you’ll find the very same mechanics that brought the subprime market from boom to bust:

  • Widespread investor acceptance
  • Complicated derivatives
  • Intense incentives for banks to make deals
  • Boneheaded assumptions of endless return on investment
  • Underqualified borrowers
  • Stunning amounts of leverage and debt
  • A loosely regulated multitrillion-dollar market
  • Overstated credit ratings from Wall Street
  • Social and political pressures to maintain growth

This crisis-yet-to-be is…municipal bonds

Munis have been a long-standing pillar of stable return. Only bonds from sovereign governments and blue chip corporations have a better reputation for credit-worthiness than munis. So when a city or state sells bonds to build a new school, sewer or stadium, investors form a line around the block. In the history of the union, only one US state has ever defaulted on its debt (Arkansas 1934). A few cities here and there have also done so. In other words, munis have performed admirably over the years.

But reputations, as this credit crisis has taught the world, no longer mean jack. Ask debt holders of “blue chip companies” like GM, or “sovereign” states like Greece. Investors are learning an old lesson the hard way: No asset class – not one in the history of the world – is a sure thing.

Though vast and complicated, the root of American municipalities is like any business or household: Money goes in, money goes out. Done right, a municipality takes in more money than it pays out. Money comes in mostly from taxes and revenue streams such as utilities and tolls. Money goes out to finance municipal government payrolls and public works programs. Cities and states sell bonds when they either can’t pay upfront for such needs. No big deal…at least, it wasn’t a big deal until recently.

In this era of high unemployment and shrinking economies, municipal revenues are hurting. Tax revenue tends to be lower with 15 million Americans out of work. Just the same, they use less power, drive through fewer tolls. Pay that parking ticket? I don’t think so…not this year.

Not surprisingly, municipalities are struggling to cut spending in line with lost revenue. But their biggest expense of all is untouchable – pension plans. California offers a telling example. A recent Stanford study concluded that the state pension fund program is underfunded by roughly $500 billion. The researchers urged Gov. Schwarzenegger to inject $360 billion into its public benefit systems – right now – to have an 80% chance of meeting 80% of obligations over the next 16 years.

Facing a $20 billion state budget gap, what can he possibly do?

It’s precisely this pickle that undid Vallejo. The San Francisco suburb declared bankruptcy in 2008. Tax revenue had collapsed, a major shipyard closed and all of a sudden the city found itself paying 90% of its annual budget to retired public employee pensions. 90%!

The problem, just like with subprime, is an irrational form of leverage. In essence, municipalities borrow current earnings of public employees in exchange for some of the most favorable retirement plans in the world. That borrowed money is invested aggressively, just like a private-sector employee would in his 401(k).

Except if the fund loses money, which they all have over the last 10 years, pension funds don’t adjust payouts. The social and political pressure to maintain the status quo – keeping our public employees comfortably retired – is just too strong.

So municipalities kick the can down the road. New employees buy into the funds. Fund managers maintain their projections of endless 8% annual returns. Retirees keep taking out the funds they were promised…and no one pays the tab.

And it’s not just California. Orin Cramer, chairman of New Jersey’s pension program, estimates a national funding gap around $2 trillion.

The municipal bond market is roughly $2.7 trillion. If Cramer is on target, that’s a total liability about the size of France and Britain’s annual GDP – combined.

Therefore, in yet another subprime redux, Wall Street has found a way to make the muni bond problem even worse. Like the mortgage market, the municipal bond market has morphed into its own new era of highflying finance, adjustable-rate loans and complex securities.

For proof, read “Looting Main Street,” a recent Matt Taibbi expose in Rolling Stone. How could a $250 million sewer project leave taxpayers on the hook for $5 billion? Easy – if you’re a Wall Street bank and you engineer a “synthetic rate swap” deal. It brought Jefferson County, Alabama, to its knees:

The county got the stability of a fixed rate, while paying Wall Street to assume the risk of the variable rates on its bonds. That’s the synthetic part. The trouble lies in the rate swap. The deal only works if the two variable rates – the one you get from the bank, and the one you owe to bondholders – actually match. It’s like gambling on the weather. If your bondholders are expecting you to pay an interest rate based on the average temperature in Alabama, you don’t do a rate swap with a bank that gives you back a rate pegged to the temperature in Nome, Alaska.

That’s the “beauty” of modern lending. This deal, struck by JP Morgan, allows a cash-strapped county to upgrade to a world-class sewage system it could otherwise never afford. The extra costs – the fees, adjustable rates and superfluous debts… That’s a problem for the next generation. Just like the state pension fund.

And as Taibbi also observed, banks pull in millions upon millions in fees for structuring these loans and swaps. Bonuses live and die by such deals. Just like the 2005 mortgage market, there is both intense demand for new age municipal financing – and remarkable incentive for Wall Street to “help out.”

Of course, what modern catastrophe is complete without a credit ratings debacle? According to the National Conference of State Legislatures, 34 states are projecting budget gaps for 2010. The total shortfall will likely exceed $84 billion. Yet only two US states, California and Illinois, are currently rated lower than AA by Standard & Poor’s. Only four states have fully funded pension programs. Yet 11 have S&P’s coveted AAA credit rating.

Given all that we’ve explored above, and the ratings agencies’ track record over the last 10 years, those AA and AAA ratings seem woefully optimistic. Insolvent is insolvent, not matter what the rating agency’s say.

For the conservative investor, therefore, our advice is straightforward: Avoid municipal bonds. For the speculating investor, check back in tomorrow to learn about a risky way to bet against the municipal bond market.

Read more: Son of Subprime

TOPICS: Business/Economy
KEYWORDS: doommonger

1 posted on 12/28/2010 5:30:26 PM PST by dennisw
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To: dennisw

IIRC, the public employee pension funds in California have taken a huge beating in the stock market. They aren’t expecting us to make up for their poor investments, right?

2 posted on 12/28/2010 5:54:08 PM PST by oldbrowser (Blaming the prince of fools shouldn't blind anyone to the vast confederacy of fools that elected him)
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To: dennisw
Kewelish title. Was all set to dig in when I scanned and saw the hat-tip to rolling stone.

thx, anyway. Just can't stomach that.

3 posted on 12/28/2010 6:01:05 PM PST by the invisib1e hand (If these are the good old days, we are so screwed.)
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To: oldbrowser

“They aren’t expecting us to make up for their poor investments, right?”

You know the problem is not related to the pension plan performance, the assumed rate of return, pension spiking practices, and general market conditions. The problem is solely due to the cheap taxpayers who want government retirees to live in squalid conditions. These cheap taxpayers underfunded our meager pensions for decades. We earned these pensions. Taxpayers and conservatives are trying to steal the birthright of government employees.

4 posted on 12/28/2010 6:02:47 PM PST by businessprofessor
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To: dennisw
Now is the time for a year of Jubilee. Wipe the slate clean and start over.


This brings us to the main subject of this writing. Verses 8 to 55 of Leviticus 25 describe the year of jubilee. The first few verses are as follows: Count off seven sabbaths of years -- seven times seven years -- so that the seven sabbaths of years amount to a period of forty-nine years. Then have the trumpet sounded everywhere on the tenth day of the seventh month; on the Day of Atonement sound the trumpet throughout your land. Consecrate the fiftieth year and proclaim liberty throughout the land to all its inhabitants. It shall be a jubilee for you; each one of you is to return to his family property and each to his own clan.

5 posted on 12/28/2010 6:07:41 PM PST by pointsal
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To: oldbrowser
IIRC, the public employee pension funds in California have taken a huge beating in the stock market. They aren’t expecting us to make up for their poor investments, right?

In fact that particular pension fund CALPERS will have towns cities counties make up for any shortfall which will force them to raise taxes. It is in the laws there

6 posted on 12/28/2010 6:45:19 PM PST by dennisw (- - - -He who does not economize will have to agonize - - - - - Confucius)
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To: dennisw
Fatal Liberality / Destruction from within bump...

It's only several hundred trillion dollars worth of "Liar Loan" derivative maggot eggs hatching and munching away within the demoralized social pyramid.... what could possibly go wrong with that?
7 posted on 12/28/2010 7:00:20 PM PST by LomanBill (Animals! The DemocRats blew up the windmill with an Acorn!)
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To: businessprofessor

Birthright? Oh I see, sarcasm. Well played.

8 posted on 12/28/2010 7:05:15 PM PST by Lurker (The avalanche has begun. The pebbles no longer have a vote.)
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