Could Credit Default Swaps Undermine the Fiscal Stability of Municipal Bonds?

Could credit default swaps undermine the fiscal stability of state and local bond issuers?
September 2010
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

For years, the municipal bond market was the securities markets' dowager queen -- regal in its slow and steady processes and super solid in its credits. The debt was a product of a growing U.S. economy that needed and could afford the improvements the bonds financed. The bonds seldom had repayment problems.

But times changed. In the last couple of decades, the municipal bond market lost its innocence as waves of financial innovation swept over it. Investors and issuers could speculate on future interest rates as embedded in the variable-rate bond and interest-rate swaps. More recently, credit default swaps (CDS) let investors bet on perceptions of issuers' ability to meet their obligations.

The CDS has a somewhat notorious past. These private contracts bet on the likelihood of default by a borrower. When default likelihood increases, the contract value to pay off in case of default increases. Unlike bond insurance, however, one need not own the defaulting bonds to collect. Rather, an investor, unrelated to the underlying transaction, can place a "side bet" that the likelihood of default will increase or decrease for a particular issue. The wild ride with the CDS in the taxable market involving subprime mortgages helped initiate the financial markets' catastrophe that launched the current Great Recession.

Around 2004, the CDS ventured into the municipal securities market but were inactive until 2008. The total amount of the CDS now outstanding in the municipal market is unknown, although markets exist for some of the individual big-borrower names. There are some gauges of CDS activity via the CDS indices, such as the municipal bond index (MCDX) that tracks a bundle of 50 municipal bonds. Today, there are perhaps $4 billion in contractual bets on the MCDX -- a very small sum compared to the many trillions of CDS positions on sovereign and corporate bonds. According to the same Treasury study, small trades of $30 million or so move the MCDX indices and the bid-ask spread on trades a large 10 basis points, which indicates illiquidity in the market. But with all the bad news pouring forth on state and local finance, bond dealers clearly have a desire to develop a way to "short-sell" municipal bonds for "real money" investors and "faux-money" speculators.

Municipal bonds, however, don't lend themselves to "short" selling. There are many small issues outstanding, and they are not homogenous. The municipal market has seen little short-term trading. Moreover, municipal securities have no record of defaulting. The mechanics of municipal bankruptcy are largely untested, uncertain, and it is not permitted for local governments in 26 states. States are sovereign and above bankruptcy. In any event, debt service is a small fraction of overall government spending. Screwing up on 5 percent of the outlays while imperiling the 95 percent of spending for years to come is a promising prospect only for anarchists.

Some state treasurers, however, are not happy about credit derivatives growth in the municipal bond market. These state officials already have many bones to pick with the underwriting firms, insurance funds and rating agencies, and they are not keen on firms that promote the CDS market while simultaneously underwriting and trading in their bonds. They reason that the speculation in the CDS market and gyrations of the CDS indices will increase issuers' borrowing costs and can drive their long-term creditors to distraction.

The newly signed Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Financial Reform Act, will bring the derivatives markets, including the CDS, into tighter regulation and increased transparency. Nonetheless, there will remain an audience for putting municipal bonds in play through CDS's use.

In the grand scheme of things, that exercise may prove to be "sucker bait" for thrill seekers: Dealers will earn commissions on trades, but investors will find little opportunity to profit even if there are widespread municipal bond defaults.

Painful adjustments lie ahead, but a widespread breakdown of government finances is not going to happen. That is not sanctimony but common sense. Systemic defaults by bankrupt governments mean unleashing a storm of chaos where private contracts, without a functioning state to enforce them, mean nothing. Pretty basic stuff.