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Muni Bailout Prospects Dim



January 08, 2011 – Comments (5)

I've been trying to follow stories related to municipal bonds lately and Fed Chairman Bernanke's testimony to the Senate Budget Committee on Friday qualifies.

IMHO, a leading contender for the next big blowup in the markets is default by a big state or several sizeable local governments.  I also believe some of those governments are able to issue bonds at reasonable rates because the market expects the federal gov't or the Fed would step in with a bailout to stop a default.

Bernanke threw a bit of a wet blanket over any hopes for that happening in his testimony.

In the Wall St. Journal report Bernanke Rejects Bailouts, the Fed Chaiman is quoted "We have no expectation or intention to get involved in state and local finance," Mr. Bernanke said in testimony before the Senate Budget Committee. The states, he said later, "should not expect loans from the Fed."

The article quotes Rep. Devin Nunes (R., CA), "There are 242 Republicans, and I can't imagine one that would be in favor of a bailout."

From the other side of Capital Hill and the political aisle, the Journal says "Neither the House nor the Senate would be "very interested in bailouts to state" according to Sen. Kent Conrad (D, ND) and Chairman of the Senate Budget Committee."

Reuters has similar reporting on the story with Bernanke balks at bailout for states.  That article leads with "Bernanke firmly said "No" after being pressed by Democratic Senators to consider a lifeline from the central bank for states where economic recovery remains elusive."

Reuters also has Sen. Conrad's reaction.  "I understand fully that's not in your domain," he [Conrad] told Bernanke. "And I can tell you I don't think Congress, the House or the Senate, are going to be very interested in bailouts to states."

When asked about Bernanke's position on municipal bailouts in an interview with CNBC's Larry Kudlow, Sen. Sessions (R, AL) said, "Senator Cornyn and I raised it, and I followed up with it and got a pretty firm commitment that they had no intention of doing that. And he indicated they have very limited legal powers to do so, only in very short-term loans. I think that was a message to every governor and every state legislature that the federal government is not here to bail them out..."

I'm a little surprised this isn't getting more coverage.  The Fed Chairman and congressional leaders from both political parties basically said there won't be a backstop for states and other municipalities.  I know, I know - they could change their position tomorrow or they could craft some kind of bailout deal, call it a jobs bill and claim with a straight face that it wasn't a bailout.

California gets a lot of press because of the size of its bond market, but I believe the most likely to go into a default or some kind of restructure is Illinois.  IL is already behind in payments to vendors and is taking some pretty, um, creative approaches to paying its bills.

I really don't know how a state default/restructuring would hit the markets, but am pretty sure it wouldn't be good.  We do have the European market turmoil as a template and, all things considered, those markets seem to be functioning ok.  Of course, there hasn't actually been a sovereign default yet.  There has been a lot of news about Greece, Ireland, Spain, and Portugal and markets, particularly banks in those countries, have been pretty volatile.  Consider that IL has a state GDP of about $500 billion.  That's about one and half times the size of the Greek economy

I also have no clue how to play this financially.  Shorting the debt of troubled issuers is an obvious possibility, but extremely risky.  The short would have to pay the bond coupons and would lose any discount to par if a bailout did come through.  Maybe buy CDS on the debt.  I don't even know how to access that market.  The 'pay the coupon' issue would go away, but a bailout or any other means of avoiding default would leave the contract worthless.

I'm don't have any muni holdings, but wouldn't necesarily avoid the market entirely if they made sense for me.  I suspect very few municipalities will default.  Even in states, counties or cities that are in trouble, some of the debt is secured by specific revenue streams that aren't in jeopardy.  I think there's too much unchared territory in the current muni market for passive indexing or etfs. Were I going to put money in munis, I think the management fee for a competent fund manager to look for the minefields missed by rating agencies would be money well spent.

The commentary above is simply my opinion and should not be considered investment advice.

Thoughts, comments, questions?

Fool on!




5 Comments – Post Your Own

#1) On January 08, 2011 at 9:36 PM, TheFoolishEdge (< 20) wrote:

Good post.

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#2) On January 09, 2011 at 3:30 AM, checklist34 (98.35) wrote:

good post.  I also have no idea where to get a CDS... or if its possible for me at this time.

However, I would offer that if you bought a CDS and a bailout became necessary, you would almost certainly have the chance to sell it for a significant profit during the leadup to the bailout (which would certainly have been preceded by huge rises in CDS rates).  That assumes that you can sell a CDS contract like you can, say, a put option.

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#3) On January 09, 2011 at 12:40 PM, Starfirenv (< 20) wrote:

Good post!   Maybe they will call it QE5 or 6?
+1 rec.

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#4) On January 09, 2011 at 3:33 PM, rd80 (94.70) wrote:

Thanks for the comments.

I have some understanding of what CDS are - basically default insurance on a bond - but don't have a good handle on how they trade.  I have yet to find a source for pricing data on them that wasn't a pay subscription service with much higher fees than I was interested in paying.

I do know there's no exchange for them, so suspect most trades are through investment banking firms with pretty high fees.  I'd also be very surprised if the value of a typical CDS contract falls in the range where an average Joe or Jane individual investor could play. 

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#5) On January 09, 2011 at 3:38 PM, rd80 (94.70) wrote:

Maybe they will call it QE5 or 6?

A steady stream of QE like that would make setting the price target for gold pretty easy.  One thousand times the QE number.

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