Something strange is happening in the short end of the Treasury securities market. Treasuries maturing in about 1 month are yielding around 0.01%. Just a couple of weeks ago, yields were above 0.10%. Perhaps this may all seem like peanuts (and it is, if you have, say, $10,000 invested). But a yield of 0.01% was last seen during the dark days of the credit crunch in late 2008 and in 2009, when the world's banking system faced a funding crisis. Such a low yield signified that no one trusted anything except the obligations of the U.S. government; that investors didn't care about getting a return. They just want to keep their money safe. The recent 90% plus drop in the short end of the Treasury yield curve in less than two weeks may be a sign that something is rotten somewhere.
Economists and other fortune tellers are raising their estimates for growth next year. Stock prognosticators are full of holiday cheer, predicting rosy returns for stocks in 2011. Consumers may be loosening their purse strings a bit for this year's holiday season. Recent tax legislation will widen the deficit for next year, ensuring that the federal spending spigot won't slow down. All systems are go, it would seem. What's to get stressed about?
Euro Mess. The European response to the Euro bloc sovereign debt crisis, generously assessed, has been tentative and muddled. The only clear impact has been to transfer risk of loss to European taxpayers and give the can a hard kick down the road. The continued uncertainty makes the U.S. greenback look good by comparison (once again demonstrating that it's easy to lose faith in America, until you look at the rest of the world). If you're going to dump Euros for dollars, it makes sense to buy the short end of the Treasury yield curve, where you're not competing against the Fed's quantitative easing program.
One group of potentially nervous investors would be money market funds that hold commercial paper of banks in shaky Euro bloc nations, like Greece and Portugal. Amazingly, in spite of the money market fund credit crunch in 2008, many money market funds bought this foreign issued commercial paper. (One wonders what happened to prudence, but then again prudence is something isn't brought up in polite company.) Those money market funds now may be quietly easing out of Euro bloc bank commercial paper and shifting into Treasuries before year end, when they'd have to disclose their holdings to investors.
Muni Mess. The muni market has fallen, about 5% in the past month. That may not sound like much, but if you held munis and it was your 5%, you'd be peeved. The future for munis isn't pretty. The federally subsidized Build America Bonds program turns into a pumpkin at the end of this year, and there won't be a fairy godmother for it next year. That means states and municipalities will face the harsh winds of the muni market without a quick fix from Uncle Sam. Many financially troubled states are still struggling with their budget problems. To make things worse, questions over states' pension accounting could compel larger state contributions to employee pension funds. Muni investors with battered portfolio syndrome may be seeking a port in the growing storm and heading for the safety of Treasuries.
Bond Mess. The bond market has fallen since early November, when the Fed formally announced its quantitative easing program. Investors who bet that QE would extend the 30 year bull market in bonds may now suspect that this time, things really are different. Those that aren't ready for the quicksands of the stock market may be parking at the short end of the Treasury curve, waiting to see whither the winds blow.
It's unclear that any of this will push the financial system back into the septic tank. Any analysis of that question would require information about who's holding what exposures in the derivatives markets. (Query: are major banks holding the hot tamale because they took the wrong end of the wrong credit default swaps?) But those markets are as opaque as ever, notwithstanding the enactment of the Dodd-Frank financial reform legislation this past summer. All we know is that the short end of the Treasury yield curve is at 0.01%, and the last time that happened, canaries in the mine were gasping.
Showing posts with label municipal debt. Show all posts
Showing posts with label municipal debt. Show all posts
Monday, December 20, 2010
Tuesday, March 23, 2010
Federalism in the Derivatives Market
Financial regulatory reform at the federal level is bogged down in a lobbying scrum. The Senate Finance Committee just voted along party lines to send Senator Christopher Dodd's bill to the Senate floor. But the outcome and timing there remains in unclear. All we know is that something might happen sometime. The subject with the least certainty of reform is the derivatives market.
The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."
The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.
Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.
Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.
Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.
Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.
Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.
The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."
The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.
Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.
Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.
Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.
Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.
Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.
Sunday, March 7, 2010
Currencies: the Latest Bubble to Burst. Is Municipal Debt Next?
In the leverage-fueled, easy money world of the turn of the 21st Century, life is just one asset bubble after another. The bubbles du jour are the Euro and the pound sterling. The Euro bloc and the U.K. seem to have achieved faux prosperity with gads of borrowed money, some of it carefully tucked away in quiet, little (or perhaps not so little) derivatives transactions.
But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.
Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.
They may take inspiration from the Chinese government. A news story today on Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=3) reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.
But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.
Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.
They may take inspiration from the Chinese government. A news story today on Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=3) reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.
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