Senior SEC Employee Warns of Potential Municipal Bond Market Collapse

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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:

  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.

Read
the rest of the article

April
7, 2010

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