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.

Here’s a myth we’d like to smash. It’s the one about how America stopped being a manufacturing economy and became a “service” economy.

The truth is found in figures like these:

  • In the late 1960s, the finance sector accounted for around 20% of corporate profits. Just before the onset of the financial crisis, it was 40%.
  • Financial stocks made up 13% of the S&P 500 in 1999. Just before the onset of the financial crisis, it was 22%.

Call it the “financialization” of the economy.

The root of the problem is the nature of investing itself – at least, the public form of investing, as practiced by most investors and as tempted by Wall Street. The idea of it is that a man can get rich without actually working or coming up with an insight or an invention by careful study or dumb luck. All he has to do is put his money “in the market” by handing it over to Wall Street, and poof! – by some magic never fully described it comes back to him tenfold.

Too often in the last couple of years, it’s felt as if Wall Street’s hocus-pocus has had the opposite result – collapsing wealth tenfold. We see it happening all over – in sovereign debt, municipal debt, even the gold market.

In yesterday’s edition of Markets and Money, I explained why municipal bonds, in general are a bad bet. The numbers just don’t add up. Municipal finances have become as ugly – and as unsustainable – as the federal government’s. Municipal obligations are simply too large, relative to current and (likely) future revenues. It is a classic “train wreck.”

All this being said, betting against municipal bonds, or funds of muni bonds, is a bad idea for most investors.

Most of the closed-end funds and ETFs that hold municipal bonds pay monthly or quarterly dividends. Which means that a short seller of those securities would have to cover them while they wait for their bet to pan out. And the muni breakdown could be months away, if not years.

Also, when muni funds do suffer, the fallout may not be as dramatic as the housing bust.

Even if you manage to pick the right municipal bond to short, it’s tough to make money. Take an ETF of Californian muni bonds (CMF). You’d think it would have suffered terribly over the last few years. But it never fell more than 20% during the worst of the credit crisis.

Furthermore, financially stressed municipalities pull all kinds of strings to avoid actually defaulting. It’s an all-too-common practice for cities and states to rescue failing projects (with taxpayer money) to prevent the repercussions of a bond default.

Those wishing to bet against muni bonds – the fates of local and state balance sheets – are better served shorting companies that hold a large portfolio of municipal bonds or those that are in the business of insuring munis. The latter category means the monolines like MBIA, AMBAC and Financial Guaranty.

As for the former, organizations with large portfolios of municipal bonds, one in particular comes to mind. It has a notoriously opaque business and balance sheet. It’s a bailed out, flailing company that also holds the world’s second largest portfolio of American municipal bonds…


“AIG holds approximately $48.6 billion of tax-exempt and taxable securities issued by a wide number of municipal authorities across the US and its territories,” its latest 10-K boasts. “The average credit quality of these issuers is A+.” It continues…

Currently, several states, local governments and other issuers are facing pressures on their budget revenues from the effects of the recession and have had to cut spending and draw on reserve funds. Consequently, several municipal issuers in AIG’s portfolios have been downgraded one or more notches by the rating agencies.

The most notable of these issuers is the State of California, of which AIG holds approximately $1.1 billion of general obligation bonds and which at Dec. 31, 2009, was also the largest single issuer in AIG’s municipal finance portfolio. Nevertheless, despite the budget pressures facing the sector, AIG does not expect any significant defaults in portfolio holdings of municipal issuers.

In our opinion, these two paragraphs alone warrant intense suspicion. AIG holds tens of billions in munis, and with an average rating of A+, a lot of them aren’t very good. The company’s stake is so big that the fate of muni bonds and AIG is intertwined.

In a company presentation to the Treasury Department, AIG warned, “A forced sale of AIGCI’s investment portfolio would significantly stress the US municipal bond market.” In short, if munis fall, so does AIG… and vice versa. Gravity, it seems, is tugging at both.

“AIG has no common shareholder equity remaining on its balance sheet,” famous short seller Steve Eisman proclaimed at Grant’s 2010 spring investment conference. “It would likely be insolvent if not for government support.”

Eisman, subject of Michael Lewis’ book The Big Short, publicly announced his shorting campaign against AIG in early April. He’s famous for nailing the subprime bust, netting his hedge fund clients ungodly amounts of money. Eisman is also often cited as mentor to Meredith Whitney, the analyst who so spectacularly called out bank stocks in 2008.

Eisman has built an argument against AIG almost as complicated and difficult to comprehend as AIG itself. We’d boil it down to this:

  • AIG, by Eisman’s estimation, carries over $124 billion in debt, even taking into consideration the possible sale proceeds of its best units.
  • The government owns 79.9% of AIG, which it hopes to sell as soon as possible.
  • Shares of AIG have soared in the last year, from $6.60 in March 2009 to just under $40 today.

Factor in a $48 billion portfolio of muni bonds we think are suspect (at best) and you’ve got a fine case for shorting AIG.

Of course, betting against AIG is not a sure thing. The principal risk is the government. It has saved AIG from bankruptcy once. There’s no guarantee it won’t do it again. The Treasury could lend more money or forgive AIG’s debt. The Fed could give greater access to lending facilities. We feel, however, that the public ire toward both AIG and taxpayer bailouts is so strong the government will offer AIG more support only under extreme circumstances.

So with the caveat that this is only for the adventurous, you might consider short-selling AIG, say, above $40 a share. Fair warning: It’s a “crowded short.” Your broker may have trouble locating shares to borrow. But Dan Amoss of Strategic Short Report agrees with Steve Eisman’s scenario: The government will convert its preferred shares to common stock – massively diluting existing shareholders and driving down the share price. Still, don’t expect this to occur until after the midterm elections in November.

Even if you don’t short, AIG, beware munis!

Addison Wiggin
for Markets and Money

Addison Wiggin
Editorial director of Markets and Money, Addison Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and a frequent guest on national US radio and television programs. Look for the sequel to Financial Reckoning Day, Empire of Debt (John Wiley & Sons) in October, 2005.
Addison Wiggin

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