Short Sellers Are Cutting Borrowing Costs of States: Joe Mysak
Investors have to pay 284 basis points to insure their California bonds, 20 basis points more than for Portugal’s. At 298 basis points, Illinois is in worse shape than Ireland. It costs more to insure the debt of New York (224 basis points) than Italy’s.
Credit-default-swap spreads show that these U.S. states are “on the brink of financial catastrophe,” according to Justin Marlowe, an assistant professor at the Daniel J. Evans School of Public Affairs at the University of Washington in Seattle.
The headline-worthy spreads haven’t harmed these issuers in the bond market. They have reduced their cost of borrowing.
“Issuers benefit when investors have access to low-cost information that complements traditional credit ratings, even if that information suggests higher default risk,” Marlowe wrote in a recent study.
“My sense is this happens because high credit default swap spreads reassure investors that a low-management-quality issuer’s ‘dirty laundry’ has been aired in full,” he explained in an e-mail. “It’s counterintuitive, I know.”
Credit default swaps, common in corporate finance, have been used in the municipal market for only a few years. Issuers are grappling with an instrument created as a form of insurance that also may be used to place bets against them. California and Massachusetts earlier this year asked securities firms how they could underwrite their bonds and sell contracts that would allow investors to bet against the states in the same way they would short stocks.
Words Matter
Marlowe’s take on why those states “on the brink of financial catastrophe” are still able to borrow in the municipal market at low rates is because “information matters.” In other words, the CDS spread is something rather than nothing, or something instead of the “rare and sporadic” price information that is standard.
That helps all municipalities, Marlowe said. “If you’re an issuer who’s doing the right thing, credit default swaps give the market a chance to recognize that,” Marlowe said in an interview this week.
Marlowe’s study is under review and hasn’t been published yet. I’m not sure I agree with his conclusion. The municipal CDS spread market is certainly worthy of more analysis.
CDSs allow investors to buy protection against an issuer failing to make debt-service payments. A basis point on a CDS protecting $10 million of debt for five years is equivalent to $1,000 annually. So, for example, to protect $10 million of Illinois bonds, it would cost $298,000.
Bets Against States
Speculators can buy a CDS contract without owning Illinois bonds, betting that the financial condition of the state will deteriorate and drive the price of default protection up to, let’s say, 500 basis points (the five-year credit-default-swap spread on Greece is 843 basis points). The speculator could sell the contract and pocket $202,000.
That’s the theory. In practice, the speculator would have to locate someone who wanted to buy that CDS protection, and the municipal CDS market is still very new. The most active seven municipal CDS contracts have a gross notional amount of about $30 billion, according to New York-based Depository Trust & Clearing Corp., which provides clearing, settlement and information services. The muni CDS market is easy to ignore.
The states with the biggest CDS spreads don’t like the company they are in.
Risky Bonds
California Treasurer Bill Lockyer wrote in March that the CDS market mistakenly branded the state’s bonds as riskier than those of Kazakhstan, Croatia, Bulgaria and Thailand. This week, CMA DataVision, which tracks CDS spreads, put those nations’ five-year CDSs at 192, 230, 260 and 111 basis points, respectively. All are below California’s.
I like the idea of short sellers in the municipal market because there’s not a lot of critical scrutiny of state and local finance and borrowing practices.
I doubt this group can deal with the illogical nature of the market. Short sellers are more used to a world in which a bust must follow when the cash runs out. Most states and municipalities don’t really have “days of reckoning.”
States, and to a lesser extent municipalities, possess an almost unlimited capacity to “kick the can down the road,” as so many people complain. Their resources are almost bottomless, their tactics unpredictable, and, of course, the angels of bailout are always at hand. I imagine that this will confound and infuriate a short seller.
This apparent game-playing isn’t an entirely bad thing, speaking as a citizen. I may wish my city to be wiser and more efficient in its use of resources. I don’t want it to go bust.
It looks like this municipal CDS market can no longer be dismissed.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net
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