Tuesday, April 6, 2010

Senior SEC Employee Warns of Potential Municipal Bond Market Collapse

Rick Bookstaber, who is a a Senior Policy Advisor to the Director of the SEC, Mary Schapiro, continues to maintain his own private non_SEC affiliated blog.

Prior to joinning the SEC, Bookstaber served as the managing director in charge of firm-wide risk management at Salomon Brothers, director of risk management at Moore Capital Management, and Morgan Stanley's first market risk manager. He is the author of three books and a number of articles on finance topics ranging from option theory to risk management, and has received various awards for his research. He holds a Ph.D. in Economics from the Massachusetts Institute of Technology.

On his blog he writes that he doesn't think:
...we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking...
He is not so sanguine about the municipal bond market:
So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

1. Problems occur when things get leveraged and complex (and thus opaque).
2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.

Well, he's a government employee, so you have to expect the shot he takes at the end, against taxpayers who revolt, but otherwise the analysis, itself, of the municipal market is strong. No one knows how many landmines are planted ready to be stepped on. Those investing in municipal bonds to get a tax break on interest earned may find out they are going to end up with a capital loss tax break instead, and no interest income at all.


  1. I smell a bailout, a la 2010, coming.

    The reason for possible defaults are simple; spending and taxes are out of sync and bonds are brought in to hide the fact. If people had to shell out in taxes what the "true" cost of government is, you wouldn't have the spending and nefarious projects being done out there.

    Who better, than BHO, to take care of the state with the most electoral votes?

  2. @ Mike in Alaska:
    I suspect we're not far from "bailout overload" which will lead to "bailout exhaustion" and ultimately to "bailout repudiation."

    The FedGov does not produce anything, and the long bond is toying with 5% yields with discussion that the USA could lose its AAA debt rating. Between now and sovereign default (a near-certainty sooner or later) it seems likely that Congressmen will try to protect their ultimate power, the power to BORROW and spend, by cutting off most of the bailouts and letting the Devil take the hindmost.

  3. The Feds will never default, as they have unlimited capital via the printing press. Unless of course you mean default by fiat currency inflation :-) They will attempt to bail out the municipalities, but I believe the public is slowly awakening to this theft and local politicians' heads will roll, so to speak.

  4. If a new congressperson gets voted in because the incumbent voted for a bailout, you can be sure that that new congresscritter will not vote for a future bailout.

  5. Talking about irrational:

    "Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with."

    "Local Taxpayers" as a whole are much less irrational than our local (and not so local) governments. Unless you consider illegal accounting methods and the ignoring and or ignorance of most laws, whether written statutes, theory such as economic laws, or natural laws, to be rational.

  6. The printing press does not produce capital. Capital comes form excess production in the form of savings. The printing press just produces more green pieces of paper that devalue bills already in circulation.

  7. Unfunded pensions will undoubtedly produce a multitude of outstretched upturned palms. "Bail me out please Ms taxpayer please."

    But what of the likes of me, who has zero pension, simply Social Security to retire on. And what happens when I am taxed to death to provide pensions for those whose pension, regardless of its corpulence, all seem as "fat cat" pensions to me who has none.

    How many like me will minimize income to avoid the death of a thousand taxes? While I have no pension, I am lucky, I have a small farm, with no mortgage. I can envision working one single day a week to meet my needs and yet to still stay below the threshold of exorbitant taxation in terms of percentage taken.

    And if millions do the same, who will care? Will my absence of four days affect anything or anyone? Time will tell, I suppose, I'm an Advanced Nurse Practitioner.

    Funny how a crisis can cause perturbations in so many unexpected areas.

  8. Welcome to the crack-up boom. "In the end we are all dead."

  9. amazing how a country with its currency as a world reserve currency become so fragile and sick. usa is living for free like a leech. free lunch. what would happen if resource rich countries demand a REAL payment?

  10. I'm not sure why you characterized the comment he made at the end as "a shot against taxpayers who revolt". Sounds more like a warning to the SEC to me.

  11. There are very few politicians that will take then necessary political heat to do the right thing. It also seems that there are very few politicians who really understand the gravity of the situation we are in; instead passing more spending bills and universal health care. As much as I would like to believe that they will do something to avoid this train wreck they (collectively) seem to have the attention span of a small knat. They don't understand the gravity of the dire situation the country is in and will NOT reign in spending until a catastrophic economic collapse is complete. That seems around the corner to me. I wish I had a farm to minimize my income because the farm will be one of the few places you will be fairly well off....

  12. looks like Birmingham Alabama is just the tip of the iceberg.

  13. vallejo ca is serving a model as well.

  14. There are some very good comments here - a great job by the readers who responded to this story.

    One reader said:
    "How many like me will minimize income to avoid the death of a thousand taxes?"

    My wife is a small business owner in California, and she is fed up by the taxes she is paying. Her business is well established, she has several employees, and under normal circumstances she would be making a good "go" of it - even during a recession. But quite frankly, for the past year it feels like all she has been doing is slaving away, under high stress, so every dollar of profit can be raked off to be paid in taxes.

    This situation is going to cause honest,hard-working Americans to give up.

    Let me ask you ... how can a minoroty of honest workers in America continue to be responsible for an economic system that is based on debt addiction in Washington DC, schizophrenic greed on Wall Street, and hopeless political quagmires in state legislatures?

    It can't be done!!!


  15. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), too soon old, too late smart

    A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged. -- now this is just stupid. Buying a policy (or ad CDS) from an party that can't cover you is just dumb. Unless you can get some fool to bail him out.

    It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. -- what we need are death panels, for retirees.

    Ladies and Gentlemen, welcome to the future that we built in the past. It may not be what we expected.

  16. it's true that things are worse than they look -- my experience with small towns is that they rival washington for corruption, which is saying a lot

    americans fail to grasp that their government is the most corrupt on earth, considering how its overwhelming indebtedness is the sign of unbounded corruption

  17. It will eventually become apparent that representative democracy is not good for the average person. The government always wants more. In order to protect yourself you have to be able to hide your wealth. In other words Get yourself some gold!!! IRAs, bank accounts, stocks are all too visible forms of wealth and are subject to confiscation. Gold is off the record and easy to hide. Forget interest and dividends, now is the time to keep what you got. Double dip is on the way soon.

  18. By the Staff of American Free Press

    Former Italian President Francesco Cossiga, who revealed the existence of Operation Gladio, has told Italy’s oldest and most widely read newspaper that the 9-11 terrorist attacks were run by the CIA and Mossad, and that this was common knowledge among global intelligence agencies. In what translates awkwardly into English, Cossiga told the newspaper Corriere della Sera:

    “All the [intelligence services] of America and Europe…know well that the disastrous attack has been planned and realized from the Mossad, with the aid of the Zionist world in order to put under accusation the Arabic countries and in order to induce the western powers to take part … in Iraq [and] Afghanistan.”

    Cossiga was elected president of the Italian Senate in July 1983 before winning a landslide election to become president of the country in 1985, and he remained until 1992.

    Cossiga’s tendency to be outspoken upset the Italian political establishment, and he was forced to resign after revealing the existence of, and his part in setting up, Operation Gladio. This was a rogue intelligence network under NATO auspices that carried out bombings across Europe in the 1960s, 1970s and ’80s. Gladio’s specialty was to carry out what they termed “false flag” operations—terror attacks that were blamed on their domestic and geopolitical opposition.

    In March 2001, Gladio agent Vincenzo Vinciguerra stated, in sworn testimony, “You had to attack civilians, the people, women, children, innocent people, unknown people far removed from any political game. The reason was quite simple: to force … the public to turn to the state to ask for greater security.”

    Cossiga first expressed his doubts about 9-11 in 2001, and is quoted by 9-11 researcherWebster Tarpley saying “The mastermind of the attack must have been a sophisticated mind, provided with ample means not only to recruit fanatic kamikazes, but also highly specialized personnel. I add one thing: it could not be accomplished without infiltrations in the radar and
    flight security personnel.”

    Coming from a widely respected former head of state, Cossiga’s assertion that the 9-11 attacks were an inside job and that this is common knowledge among global intelligence agencies is illuminating. It is one more eye-opening confirmation that has not been mentioned by America’s propaganda machine in print or on TV. Nevertheless, because of his experience and status in the world, Cossiga cannot be discounted as a crackpot.

  19. Well. I'm a banker in Pa. and am already planning my move to part time status because of over taxation. I am no longer looking to move up the ladder to a better position just to end up paying uncle sam. We have no doubt reached the point where productive people are backing away from supporting the fat state and local DB plans and now the new healthcare handouts.

  20. It's good to be safe. Surely, he'll receive constant comments and I'm sure majority of the comments are contradictory.