Monday, June 13, 2011

Wll the Ghost of Lehman Crash the CDS Municipal Bond Market?

WSJ is reporting that
The firm charged with winding down the estate of the bankrupt Wall Street firm has been looking to sell a portfolio that includes credit-default swaps on $8 billion worth of municipal-bond debt in several states, according to court filings...The exact timing of Lehman's sale is unclear, but some traders and investors say the mere prospect of such volume hitting the market has been a factor in driving down swap prices over the past month. The Lehman portfolio amounts to about a quarter of the total known supply of outstanding swaps on large individual municipal issuers, according to industry estimates.

These types of swaps allow investors to bet on the likelihood of an issuer's default. In normal circumstances, the lower the swap price, the lower the market's perception of default risk. But some investors argue that Lehman's huge sale is helping drive down swap prices even though risks associated with municipal debt in some states, such as California, haven't gone away.

"The Lehman unwinding is driving California CDS artificially low,'' says Adam Fisher, chief investment officer of Commonwealth Opportunity Master Fund Ltd., a Los Angeles hedge fund that is bearish on the state's debt. "The state still has enormous problems."
Over the years, I have seen many liquidations that have caused short-term distortions in the market. The current Lehman liquidation appears to be having that impact on the muni CDS market. Once the liquidation is completed, the muni CDS market is likely to rebound. Thus, anyone looking at the current weak muni CDS market as a sign of an increasing optimistic view of the muni sector is way off. The ghost of Lehman Brothers is just casting a long shadow that will eventually disappear as dusk turns into darkness.

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