MarketNeutral
8th April 2010, 11:27 AM
http://www.lewrockwell.com/spl2/municipal-bond-collapse.html
Rick Bookstaber, who is 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:
Problems occur when things get leveraged and complex (and thus opaque).
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.
The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recessionâ€), works fine – until it doesn’t.
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.
Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
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.
Rick Bookstaber, who is 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:
Problems occur when things get leveraged and complex (and thus opaque).
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.
The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recessionâ€), works fine – until it doesn’t.
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.
Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
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.