Mismanaged States Blame Messenger
Mismanaged municipal and state governments around the country are finding a new target to blame for their own self-inflicted wounds: the growing market for credit defaults swaps (CDS) on municipal debt.
A municipal credit default swap would be a derivative that pays off in the event of default by a specific state or a default on one of said state’s debt instruments.
As reported in today’s Wall Street Journal, a handful of state treasurers are demanding information from Wall Street firms on who exactly is “betting against” these states.
It should come as no surprise, except to state officials, that the major buyers of these CDS are the very bondholders investing in their state. In fact the availability of municipal CDS will likely increase the demand for municipal debt. Just speaking for myself, there’s no way I’d buy debt issued by California if I couldn’t at least hedge some of that credit risk
Of course states complain that “betting on a default creates a perception of risk,” as if there wasn’t already a widespread perception of risk to investing in municipal debt of certain states. The states also express concern that adverse movements in the price of CDS could impact their credit ratings, and hence their cost of borrowing. Given the slow speed of which credit ratings moved on sub-prime mortgage debt, I am not sure that cities and states have much to worry about rating agencies being “too aggressive”. If these states had even a small understanding of how markets work, they’d understand the rating is just one element that goes into pricing. Witness the large spread in yields of similarly rated debt. No rating, or credit default swap price for that matter, is going to fool investors into believing that many American local and state governments are just anything other than mini versions of Greece.
Who’s Going to Buy Your Debt, Mr. President?
The administration’s presumption that America can borrow its way to prosperity has taken a couple of big hits over the last couple days.
First, just as the Third World debt crisis destroyed the belief among international bankers that countries don’t go bankrupt, so is the West’s borrowing binge ending the belief among international investors that the U.S. and other Western nations are safe economic bets.
Reports the Wall Street Journal:
Britain was warned by Standard & Poor’s Ratings Service that it may lose its coveted triple-A credit rating, triggering a drop in U.K. bonds and sparking global fears about the consequences of massive debts being incurred by the U.S. and other major nations as they try to dig out from the economic crisis.
…
The announcement quickly sent waves across the Atlantic. Investors initially dumped U.K. bonds and the pound, heading for the relative safety of U.S. Treasurys. But within hours, worries about an onslaught of new U.S. bond sales and the security of America’s own triple-A rating drove down the prices of U.S. Treasurys.
The yield of the benchmark U.S. 10-year bond, which moves in the opposite direction to the price, rose by 0.15 percentage point from Wednesday to 3.355%, its highest level in six months.
The relative gloom about the U.K. and the U.S. was apparent Thursday in the market for credit-default swaps, where investors can buy and sell insurance against sovereign defaults. Five years of insurance on $10 million in U.K. debt jumped to around $81,000 a year, from $72,000 earlier in the day. U.S. debt insurance cost the equivalent of $37,500 — in the same range as France at $38,000, and Germany at $35,000.
A shot across the bow of the American ship of state, some analysts have called it.
But shots also were being fired from another direction: East Asia. The Chinese are starting to have doubts about Uncle Sam’s creditworthiness. Reports the New York Times:
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