Mayhem and the Markets

It is an understatement to say that the financial markets are in an "unsettled" state. They are in paroxysms of uncertainty. For those in charge...
by | May 31, 2008

It is an understatement to say that the financial markets are in an "unsettled" state. They are in paroxysms of uncertainty. For those in charge of investing state and local monies -- from cash managers to pension officers -- it's no longer a matter of facing higher risks. Risks are something that can be calculated and compared to potential loses or rewards. Today, the financial markets are haunted by unknowns. Hundreds of billions of dollars of bad investments are spinning around while no one is sure who owns them, much less what remaining value they possess. Yet, there's ready agreement about where the markets are heading: south, dragging the real economy -- jobs, incomes, profits -- with them. Nobody knows how far down the bottom will prove to be or how hard the landing.

In recent years, it's been relatively easy to describe the investment markets that affect states and localities. They would have their flare-ups -- the security markets might get roiled -- but calm generally followed the storms. After the stock market's dot-com bust of the early 2000s, for instance, there ensued half a dozen years of low interest rates, low inflation and a slow but promising stock market recovery.

Last year, that changed. The subprime mortgage crisis, which started out as a disturbance on the verges of the market, gathered force and began to sweep through the financial world like a tsunami, inundating banks and investment firms, the credit rating agencies, financial insurers and, of course, investors. Overnight, confidence in the entire system weakened and, despite the efforts of federal monetary authorities to shore things up, the vast ocean of credit began to recede. Banks have curtailed lending, businesses have cut back on investing and consumers are no longer non-stop shopping. And that means that a huge aftershock is threatening to strike the real economy. Investors, including state and local governments, have been scampering for higher ground.

But where is that ground? And how can public-sector investors deal with the dual pressures of the need for a safe place to park the public's money and the demand to bring in high yields on that money -- in markets beset by confusion, uncertainty and radical change? Figuring out where to go depends in part on understanding how this financial maelstrom started and where the economy is heading.

The Froth Rises

If there is a single villain (albeit with lots of accomplices), it is the drastic run-up in housing prices. For more than a century, housing prices moved pretty much in step with the rate of inflation. There were some notable exceptions -- times when periodic losses and subsequent growth were in the range of 20 to 30 percent over a decade or so, such as during the Depression, the World War II years, and in the early 1990s. Between 2000 and 2006, however, prices of houses increased by 110 percent -- three times the highest rate of growth in prices ever experienced.

Homeownership rates spiraled up as lending standards slipped and became most egregious in the case of subprime mortgages. In a fashion akin to the dot-com bubble, where stock prices became unhinged from earnings, the price of assets (the houses) became unhinged from the incomes of those buying them.

A lot of the "frothiness" in the market -- Alan Greenspan's term -- stemmed from big changes in how housing was financed. New channels to deal with the growing amount of mortgage debt opened up, foremost among them the repackaging of mortgage debt into securities that could be marketed broadly. By 2006, $7 trillion in mortgage-backed securities had settled in the portfolios of individual investors, banks and financial institutions around the world.

Along with that securitization came the invention of other vehicles to finance long-term debt using a variety of low-cost, short-term funds. These Special Investment Vehicles (SIVs) would borrow short-term in the blossoming commercial paper market in order to finance portfolios made of mortgage-backed bonds. The dramatic run-up in housing prices and the low default rates stemming from a low-interest rate environment made it all seem pretty safe and secure. Leveraging -- a whole lot of borrowing in relationship to equity -- ruled the day and was written into the structures of the securities. "Times of low interest rates," one banker says, "meant increasing risks and leverage in order to satisfy investors' demands for better returns."

By early 2006, the excesses became evident. Rapidly increasing foreclosure rates in subprime loans started to undermine the ever-more-complicated devices developed to package and repackage debt. Banks scurried to move these devices off their balance sheet (where they would require the provision of reserves) into the specialized vehicles. Risk was sold off to others through credit swaps. Much of this was made possible by bond-rating companies that were accommodating in slapping investment-grade ratings on the various obligations.

When the froth went out of the housing market and housing values began to fall, homeowners -- many of whom had leveraged their homes through refinancings -- began to feel the pain. We are now in the midst of a storm of foreclosures and a real estate market that's in disarray. At the end of March 2008, the S&P Case-Shiller Housing Index for 20 cities was down about 13 percent over the previous year and still in a dive. Many say we are halfway down to the bottom.

A Credit Crisis

Those mortgage securities and other structured-debt instruments that the financial industry had pieced together and held as yield-bearing investments were based on strong and ever-growing housing values and on the ability of homeowners to pay their mortgages. Now, billions of dollars worth of assets have begun melting away, along with the capital and liquidity of banks and investment banks. The International Monetary Fund in its latest report on the world's financial markets indicated that the total write-offs of bad loans had reached $550 billion through the end of 2007. The report's analysts suggested the figure would reach a little under $1 trillion by the end of 2008.

The Federal Reserve has been trying a variety of devices to pump funds into the U.S. banking systems. In January, it lowered the discount interest rate by an extraordinary 2.25 percent. But, long-term rates have stayed high and money to loan is scarce.

Compounding these woes was the dramatic implosion of the bond insurance companies. They had added on to their basic and low-risk business of insuring state and local debt, by underwriting mortgage securities and other structured-debt instruments. As the structured finance market failed, the bond insurers were threatened with bankruptcy -- which in turn undercut their credit ratings and therefore the ratings of municipal debt that carried insurance.

These currents and undercurrents took their toll on what had been considered low-risk investments, such as auction-rate bonds. These structures were set up early in the 2000s during a period in which short-term interest rates were much lower than long-term rates. This steep yield curve created an opening for long-term borrowing to happen at short-term rates. The answer was to use variable-rate structures, such as auction bonds, to reset the interest rates on long-term debt on a weekly or monthly basis. Since the rates were subject to continual re-setting, the investors in the bonds felt protected against interest-rate fluctuations that would change the value of their holdings, and borrowers got the advantage of lower borrowing costs because they paid short-term rates to finance their debt. Investment bankers, for a fee, ran the frequent auctions, where the rates of interest were determined. In the process, they usually agreed to pick up any bonds that weren't auctioned off.

The auctions worked fine as long as short-term rates were low and markets were stable. But then the credit storm struck. The investors who usually bought the bonds refused to bid for them or only did so at high rates -- even though the bonds were insured, which itself was part of the problem since the bond insurers' ratings were under assault. Meanwhile, the underwriter firms running the auctions no longer wanted to take bonds on to their own rapidly dwindling balance sheets. Interest rates on the auction securities soared for the borrowers, sometimes to as high as 20 percent, and issuers such as New Hampshire and New York got blasted with unexpected interest charges. Investors who had bought the auction-rate bonds thinking they had safe and liquid investments were suddenly locked into holding the bonds, which were trading below their purchase price.

The auction-bond crisis also played a role in the fiscal disaster in Jefferson County, Alabama. In an effort to lower its debt service costs on $3.2 billion in sewer-improvement debt, it included $2.2 billion in auction-rate securities in the deal. It also entered into about a dozen swap agreements worth some $5.4 billion. As a result of all this financial creativity, the county has fallen into the "perfect storm" of fiscal distress. It is buffeted by the collapse of the auction-rate securities market (where it has been paying 10 percent -- about three times municipal one-year rates -- for short-term lending), by the blowing up of its bond insurers and by the terms of the swap agreements. The details of the swap agreements are not public knowledge, but evidently they are written in such a way as to require Jefferson County to put up more collateral given certain circumstances, such as a decline in its bond rating. In March, the county was asked to come up with $185 million in cash collateral under the swaps, which it declined to do. The county is attempting a workout but also is talking about entering into bankruptcy. With all those goose eggs behind the figures, it would be the biggest municipal bond default since Washington State's WPPS ("Whoops") default that occurred in the early 1980s. That one was worth $2.25 billion.

The Cash Question

Even with all that uncertainty and danger in the investment market, state and local governments still need to park their revenue somewhere. And there is a lot of money to manage -- about $1.5 trillion in assets at latest count (not including the pension systems). More than one-half of that represents various long-term investments by trusts and funds, but a major chunk -- $600 billion to $700 billion -- is just cash temporarily passing through a system that taxes and spends $2 trillion a year.

Over the past few years, the management of cash funds has been pretty unexciting stuff. Although interest rates were low, revenues were rising steadily, so there weren't extraordinary pressures to maximize short-term returns. Still, even in the low-interest-rate environment, it was attractive to come up with an investment option that offered a bit more yield. The yield chasing, while reasonably subdued, nonetheless led to putting money into unfathomable and unwieldy financing structures that created more risk than was perceived.

An example of the current difficulty is found in Florida. Last November, the state-sponsored local government investment pool there suffered a run on the bank, amidst rumors that the pool had funds in investment vehicles related to mortgage-backed securities. Within a few days, several worried governments withdrew their money, and the pool sank from $27 billion to $10 billion. The rumors were not without foundation. The pool, which had had about 1,000 state and local government members, had paid a relatively high rate on short-term investments, about a percentage point higher than available on other short-term investments. The difficulty was that it had a large amount of funds tied into investments in mortgage-backed vehicles, which suffered substantial rating downgrades and had lost their marketability. The surge of communities getting out of the pool brought a temporary suspension in withdrawals, which proved a major burden for small municipalities that were used to using the pool as a liquidity facility.

Although nobody has lost money (except for those governments that chose to pay a withdrawal fee), some depositors were forced to borrow money to meet payments that were supposed to be covered by the frozen deposits. In the wake of the near-collapse of the state investment pool, several localities in Southern Florida established their own pool in March, with promises of investing only in liquid government securities.

Other than the Florida problem, there have been only a few reports of cash management difficulties arising from the mortgage-market maelstrom. More critical to financial health is the performance of long-term investments: Can it live up to expectations?

The Long Haul

State and local pension systems are huge investors. As of the end of 2007, they had about $3.2 trillion in assets -- 90 percent of it meant to fund fixed-benefit pensions for 20 million current public employees and 7 million retirees. While seed-money funding for those pensions comes from contributions, most of the growth will come from the earnings on invested assets. And therein lies the latest rub. Most pension systems assume rates of return on investments of 8 to 8.5 percent, but that may no longer be realistic. Financial wizards such as Warren Buffet believe that lofty long-term rates of return are no longer obtainable and that rates of 5 to 6 percent are more likely.

The pension systems, which are the ultimate long-term investors, have been faced with difficult markets for several years. They entered the 21st century with a major bet placed on stocks, a bet that rewarded them spectacularly in the 1990s. The dot-com bust that followed was a disaster, as pension systems suffered major erosions in their asset values. But after the market lows in 2002, the next five-year run of pretty good returns promised recovery. The latest quarter of bad news, of course, is not the real concern. It's that the 10-year return is not looking good.

Faced with low returns on equities, the pension systems have been searching for alternatives. One favored choice has been hedge funds. Several pension funds have followed this tack with some success, but there is great difficulty in getting a handle on which hedge funds have done well and how well they have done. A few hedge funds, which charge high fees to be smarter than the market, have collapsed, while others have reported spectacular gains. But as a huge, unregulated family, they do not disclose their holdings or the value of their illiquid holdings. So the performance of their "black boxes" remains a mystery to outsiders.

There are signs of worry about these funds. About two-dozen hedge funds have recently locked in their investors, with no or limited withdrawals permitted. Obviously, in these markets, there is no desire to liquidate holdings to make cash disbursements. On the other hand, regulatory authorities are aware that the hedges are now an enormous factor in achieving market stability and are reluctant to be hasty in roping them in -- just yet.

Another investment alternative that has gained interest is the commodities markets, where there has been a steep run-up in the prices of various crops and metals. Large pension systems, such as California's CalPERS, now see this as a long-term market investment, one in which, given world shortages and lusty demand, prices seem destined to grow. (CalPERS earned a towering 33 percent in 2007 on its investments in commodities.) The growing interest in the commodities alternatives is part of a strategy to replace corporate bonds and stocks and to go more heavily into inflation-proof vehicles. One might wonder what an investment emphasis on basic commodities says about the long-term prospects for the world's most sophisticated economy.

More Wild Rides?

The Economist magazine (which never saw a market it didn't love) sees many culprits, aside from the finance markets themselves, to blame for the present financial crisis. In its view, monetary policy allowed credit to become too cheap. Interest rates were kept too low for far too long. Fiscal policy over-encouraged homeownership and failed to balance the federal budget. Tax policies and regulation forced banks to do things off the balance sheet in order to compete and to avoid building up their reserves. Somehow, it seems, government is to blame for building the wrong incentives into the system.

Others are less forgiving of the market itself. There were no natural disasters, no strikes and no revolutions to explain this financial disaster. A market allowed to run wild undid the hinges of value. Crises, it seems, are inherent in market economies. Finance is the brain of the capitalist system: It matches capital with labor and provides a way for people to defer consumption and to share and trade risks. Things tick along, but then there is the inevitable crash. So, some ask, if the market brain is now preoccupied with short-term personal gains, can it be made to think about the right things for all of us?

It is too early to say how state and local investors (or the state and local bond market) will be affected by changing regulatory structure in the United States or what reforms will be made. Current guesses are that it will take several years for the changes to unfold, because the existing system, for all its ups-and-downs, has its powerful defenders. This spring, U.S. Treasury Secretary Henry Paulson blew the dust off an earlier proposal to streamline the financial regulatory system, giving the Federal Reserve Board a more general charge to ride the financial herd and investigate problems in the system, while relieving it of much of its bank regulatory powers. But don't hold your breath. The United States does not appear to be on the verge of having a super-agency to oversee all aspects of the financial system, such as is found in Great Britain with its Financial Services Authority.

Meanwhile, the Federal Reserve has recognized its de facto role of being the "lender of last resort" to investment banks, a zone of commerce in which it has neither made loans nor exercised regulatory authority in the past. The basis for intervention is a simple one: The old notion of a "bank" is out of date when it comes to maintaining financial stability. Bear Stearns, the Wall Street firm that had to be rescued earlier this year, while not a commercial bank, was so thick in the middle of credit creation via a network of swaps, SIVs and its hedge funds that its impending downfall threatened to slosh throughout the system. The Federal Reserve, a trained lifeguard, jumped in to the rescue, even though the saved soul was not a dues-paying member (and had not behaved very well over the years).

So state and local governments are again reeling in the midst of fiscal storms. The precipitous drop in housing values is eroding property taxes and many tax systems are heavily reliant on construction spending and all that consumer spending that went along with the housing boom (and the tapping of equity to support consumption). To some degree, states and localities are "innocent bystanders" of the financial meltdown that has occurred and suffered collateral damage in a financial system that went out of control. They paid for bond insurance that proved to be worthless and for ratings that made them jump hurdles that were much higher than their corporate brethren had to jump. But they have a lot riding on getting the markets settled and the system fixed. Most pointedly, the liabilities are rapidly adding up on pensions and health care. Achieving sufficient investment earnings to pay those future costs is the number one issue. Now, if there were any money left over to pay for mounting infrastructure needs, that would be nice as well.