Posted by Kenneth Anderson:
Risk Shifting that Might Turn Out Not to Shift Risk?
http://volokh.com/archives/archive_2009_06_14-2009_06_20.shtml#1245163325
The WSJ money and finance page had a s[1]tory on Monday, June 15,
2009, about the return of an old financial product in new clothing for
the municipal bond market. That market has suffered as concerns about
municipal and state finances grows while concerns about the
guarantors, explicit and implicit, by banks and financial
institutions, has grown even faster. The problem has always been one
of borrowers wanting to borrow for the long term but paying short term
rates:
Much like auction-rate, variable-rate, and corporate floating-rate
debt, the new tax-free "Windows" or "X-tender" securities offer
municipalities the ability to borrow for the long term while paying
only short-term interest rates.
This model proved dangerous during the credit crisis. Banks and
bond insurers -- who offered both express and tacit guarantees to
backstop the debt -- failed to live up to some of their promises.
These securities became untradeable and dropped in value, leaving
money-market funds in jeopardy of "breaking the buck." Borrowers
like municipalities, nonprofit institutions and student-lending
companies faced penalizing interest rates well over 10% for months.
Let me say that the idea that money-market funds could actually be
riskier than federally insured depositary accounts certainly gave me
pause - though obviously it should not have, since every statement for
my money market fund said explicitly not insured by the FDIC, but I
treated it as all interchangeable, risk-wise, and the Federal
government quickly stepped up to the plate and covered my exercise in
moral hazard, and yours. The lesson that Wall Street seems to have
absorbed is that the banks and bond-insurers didn't pay off as
planned, or were at risk of doing so, and therein lies the source of
potential trouble. So the new (old) instruments shift the risk onto
the municipal issuers directly:
Like auction-rate securities and other variable-rate debt, the new
instruments have an interest rate that resets every week, but this
one is based on a short-term municipal debt index. The securities
act like short-term debt and are appealing to money market funds
that need to be able to sell their investments quickly.
This time, though, the banks removed some of the weak links from
auction-rate securities and variable-rate demand bonds. Instead of
banks or bond insurers acting as a guarantor or buyer of last
resort at the auctions -- which they were increasingly forced to do
last year -- the borrower itself promises to accelerate repayment.
The borrower has seven months to repay.
The question, of course, is whether this structure is stronger or
weaker than the one it replaces. It addresses institutions that
failed, or were at plain risk of failing, to meet their promises
explicit and implicit. But does anyone think that the true problem for
investors is solved by putting the burden onto municipal issuers? This
is so obvious a point that I wonder if there is not a political,
rather than economic, motivation behind it - the assumption that the
Federal government serve as the guarantor of last resort if or when
local governments and states begin defaulting:
That structure puts greater risks on the back of the borrower,
which needs to come up with the money to repay bonds. The risks
also flow to money-market funds, which must be able to easily sell
holdings in order to keep each share at $1 at all times.
Despite the risks, the Securities and Exchange Commission blessed
the instruments, allowing money-market funds to buy the debt.
Banks are also taking advantage of pent-up demand from
municipalities that need money. Outstanding issuance of
variable-rate debt has shrunk by approximately $100 billion in 2008
-- a 20% drop, according to Municipal Market Advisors. The banks
are now estimating as much as $10 billion in such "Windows" deals
could hit the market over the next six months. So far, at least two
municipalities have sold the debt and another deal is close to
completion.
Some fund managers aren't convinced. Steven Permut, senior vice
president at American Century Investments, which has a pair of
tax-free money-market funds, said he was "uncomfortable" with the
product as proposed, because it would expose his funds directly to
the risk that an issuer didn't have adequate cash to refinance in
difficult market conditions.
I'm with Permut on the risks here. It's not just California; it's all
those local government entities, too, in places you've never heard of.
But given the demand for municipal financing, the increased expense of
bank bond guarantees and the questions about them, but also the mounds
of cash sitting in the funds in a world of super-low short term rates:
"The money funds are being forced into being more aggressive," said
MMA managing director Matt Fabian.
With short-term interest rates at historical lows, funds are
reaching to riskier products for higher yields. "They've become
increasingly liberal in the structures they will accept because
they're sitting on so much cash," said Mr. Fabian.
References
1.
http://online.wsj.com/article/SB124502161222713785.html#mod=todays_us_money_and_investing
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