Goldman Sachs Advising Short Positions on California, Wisconsin and New Jersey

Goldman Sachs, one of the top five U.S. municipal bond underwriters, is angering politicians and public-finance officials in New Jersey, Wisconsin, California and Florida by recommending that investors purchase credit-default swaps to bet against 11 states’ debt, according to Bloomberg.

In the three months since Goldman recommended “shorting municipal credit,” the value of the Markit MCDX index of the derivatives’ price more than tripled, to as high as 278.33 basis points from 87.75. A basis point on a credit-default swap protecting $10million of debt for five years is equivalent to $1,000 annually.

It’s “disturbing” to advise investors to bet against the financial health of a state whose bonds Goldman helps sell,New Jersey Assemblyman Gary S. Schaer, a Democrat who chairs the Financial Institutions and Insurance Committee, said last week in a letter to Chief Executive Officer Lloyd C. Blankfein.

“New Jersey needs to maximize its presence in the credit markets, not to see its presence undermined.” Schaer wrote.

Short sellers borrow securities to sell, betting their value will decrease. Credit-default swaps, conceived to protect bondholders against default, pay a buyer face value in exchange for the underlying securities or the cash equivalent should an issuer fail to adhere to debt agreements. They increase in value as perceptions of credit quality deteriorate.

As part of a September presentation to institutional investors on “Best Long and Short Risk Strategies,” Goldman recommended buying credit-default swaps on “a basket of liquid State General Obligation credits with current and worsening fiscal outlooks,” including California, Florida, Nevada, Ohio, Wisconsin and Michigan.

The firm also recommended the derivatives on states with “significant unfunded pension” and other retiree obligations, including Illinois, Connecticut, Hawaii, New Jersey, Massachusetts and Nevada.

Markets Indicate Growing Concern of Potential Bankruptcy By Some States

The credit default swaps of 5 states are now trading at over 100.

Michigan 192
California 165
Nevada 164
New Jersey 150
Ohio 104

These are not total panic levels, but they are very high. It shows increasing concern about holding paper from these states.

Credit default swaps are often used to manage the credit risk (ie the risk of default) which arises from holding debt. Typically, the holder of, for example, a government bond may hedge his exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.

For example, a pension fund owns $10 million of a five-year bond issued by Country X. In order to manage the risk of losing money if Country X defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 100 basis points (100 basis points = 1.00 percent). In return for this credit protection, the pension fund pays 1% of 10 million ($100,000) per annum in quarterly installments of $25,000 to Derivative Bank.