Wednesday, 14 May 2008 06:00

The Municipal bond market and the securitization crisis

Note: for some arcane reason, the graphs refuse to show up on this post so here is a pdf version for the blogs registered users: icon Municipal Bond Market and the Securitization Crisis (242.88 kB 2008-05-14 18:09:27)

his is a DRAFT of part 5 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment covers consumer finance, an aspect at risk in the banking system that is both overlooked and underestimated, in my opinion.

I urge discourse, conversation and debate on this post and the entire series. To me, it is necessary to make sure the world is as I percieve it.

The Current US Credit Crisis: What went wrong?

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. You are here => Municipal bond market and the securitization crisis – where do we stand
  6. To be Published: An overview of my personal Regional Bank short prospects

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year.

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through c

And now, on to the Muni report...

Municipal bond market and the securitization crisis – where do we stand

As defined by the Securities Industry And Financial Markets Association (SIFMA), municipal bonds (often called munis) are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good. The interest income generated from these bonds is free from federal taxes, state taxes, local taxes or all the above. However, not all munis are tax-free.

Municipal bonds generally are classified as general obligations and revenue bonds. General obligation bonds (or GO bonds) are mostly backed by the credit and the ‘taxing power’ (inflow of tax revenues) of the issuing municipality. They are generally considered one of the safest investments as they have governmental support.

Revenue bonds, on the other hand, depend upon the revenue generation capability of the project in which the bond proceeds are to be invested. Hence, they are generally perceived to be riskier than the GO bonds.

Out of a total market worth US$2.62 trillion municipal bonds outstanding, mutual funds hold the maximum (35.8%), while individuals hold the second highest amount (35.0%) of the municipal bonds in the US.

Municipal bonds breakdown - outstanding and issued in 2007


Source: SIFMA

From the issuance perspective, revenue bonds have almost always attracted more investors due to their higher paying nature. Consequently, revenue bond issuance has grown at a CAGR of 8.4% in the last 12 years as compared to 6.6% for GO bonds. In 2007, the total municipal bonds issued were worth US$424.3 million, of which revenue bonds issued constituted 69.1%.

Most municipal bonds are insured by bond insurance companies. According to the S&P National Municipal Bond Index (which comprises 3,102 bonds) at the end of 2007, 48.8% of the municipal bonds were insured.

The impact of the Asset Securitization crisis on municipal bonds

The municipal bond market was severely impacted during the second half of 2007 as compared to the first half.

Property tax revenues of local and state governments severely impacted

Most local and state governments rely on taxes as their major sources of income; hence it is obvious for them to raise money through bonds based on their taxing powers. Moreover, each of the 50 states has different definitions of “property”.

There were two taxes that were primarily affected as a result of the housing market downfall – property tax as well as use tax on rents. Property tax is a primary source of income for most state and local governments in the US, states the US Treasury Department. There was a rapid decline in demand for real estate which was augmented by increasing supply of homes on account of rising foreclosures. As a result, property valuations went significantly down which affected the tax inflows of many states in the US. Moreover, with people not able to service the rents, even the income through use taxes suffered. An evidence of such a state is California. California was home to almost half of the 25 biggest US subprime lenders. According to the California Association of Realtors, the number of houses and condominiums sold in California declined approximately 30% y-o-y in January 2008 to 313,580, while the median price for an existing home slumped 22% y-o-y to US$430,370. Moreover, California had 481,392 foreclosure filings on properties last year, the most of any state, according to RealtyTrac.

As a result, the state’s Director of Finance expects the growth rate in property tax revenue to be as low as 2% y-o-y in 2008-2009 with an expectation of a 6% y-o-y fall in 2009-10. According to the California Legislative Analyst Office, a 1% y-o-y decline amounts to US$450 million of lost tax revenue (for those who don’t want to do the math, that’s approximately $2,700,000,000).

Lower income tax revenues due to economic slowdown

For the US Federal Government, income tax charges contribute most to its revenue, with personal income tax producing almost five times the revenue produced from corporate income taxes. In 2007, of the total Federal revenue collection, income taxes from individuals constituted 78.5%.

Importance of income tax revenues to the US Government

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Source: Financial statements, US Federal Reserve

With the economic hard landing in the US, income tax collections are likely to get hit, going forward. According to advance estimates from the Bureau of Economic Analysis, the US economy grew by only 0.6% y-o-y in 1Q 08 with unemployment rate having jumped from 4.5% in April 2007 to 5.0% in April 2008. With high food prices across the globe, higher fuel costs, increasing debt component pressurizing the household income and the decline in the values of houses of US citizens, there is an unavoidable pressure on personal disposable income. With rising unemployment across the country, a declining or even a marginally negative growth rate of revenues generated through income tax would severely pinch the Government’s earnings. With homeowners expecting at least as much assistance as was provided to the financial industry, tough times await the US Government.

An impact in tax revenues directly affects the credibility and capability of the government to issue any bonds based on its taxing powers – whether they be municipal or federal. This is also a major reason why the overall outlook for municipal bonds market appears grim in the near to medium term.

Bloated budgeting in the boom times

Most US state and local governments had prepared budgets based on the revenue from the (then) extant real estate boom. Hence, they continued to issue munis to fund their expansion plans; even the interest rate scenario was conducive and they could pay the investors due to a consistent inflow of taxes. However, after the housing market collapsed, property values went down and an increasing number of homeowners went for the property revaluation to cut down the property tax figures from the list of their financial obligations.

Consequently, tax inflow for these state and local governments slowed down. Due to this, payments on the long term municipal bonds became riskier than at the time of their issue. The government of California has already reduced the budgets of its police and fire departments for the coming year by approximately 20% following these developments. This, combined with private sector workforce reductions, serve to act as a reflexive mechanism that causes a feedback loop, wherein cost reductions reduce income tax revenue which exacerbated the need for further cost reductions.

Credit crunch takes toll on the ARS market – auction failures rise alarmingly

The adjustable rate securities (ARS) market was another victim of the asset securitization crisis. The ARS market works with an intention of matching the long term needs of securities issuers and the short term need of the investors. It accomplishes this through the Dutch auction process. Generally, ARS issuers are state and local governments, non-profit hospitals, utilities, housing finance agencies and student loan finance authorities and universities. The total ARS market was worth US$330 billion at the end of 2007, with majority ARS comprising of municipal bonds.

ARS market – composition as on 31 December 2007


Source: SIFMA

Since the beginning of the crisis, the reason for the downfall of the ARS market was the declining credit standards of bond insurance companies. As the bond insurance company’s rating fell, it created a “perfect storm” for the ARS market:

  • Investor wariness about the issuer’s repayment abilities increased,
  • General investor sentiment soured and risk aversion ran rampant,
  • The broker/dealers who historically served as both market makers and buyers of last resort for these securities refused to purchase unsold securities as then have in the past (primarily due to their own financial woes as well as their significant exposure to the monolines as counterparties).

As a result, the proclivity to invest in ARS reduced which led to increased failure of auctions. An auction “fails” if there are not enough buyers to purchase all the securities put out for sale. In such an event, the issuer has to pay the holders the maximum interest rate specified in the official ARS documents. This was a double whammy to the issuer – not getting enough investors plus paying high interest to existing investors. Consequently, the overall cost of funds for these issuers significantly went up. This affected the municipal bond issues and the ARS market as a result, as municipal bonds comprise maximum of the ARS market. To throw salt on the wound, broker/dealers often sold interest rate swaps to municipalities as a hedge, or an income kicker, along with the ARS deals. Many municipalities not only had significantly higher ARS payments, but also witnessed their interest rate swaps turn against them, forcing their payments even higher.

Increased risk in interest rate swap deals

After the securitization crisis ratcheted up mid-2007, banks began to face major problems as lending became riskier and banks were unwilling to lend to each other even at higher interest rate. With credit difficult to obtain, the counterparty risk associated with interest rate swaps began to increase. This led to the well-rated companies also being exposed to counterparty risk.

This is a monthly plot of interest rate on a 10-year US Treasury bill versus the interest rate on a 10-year interest rate swap. The increasing spread from 2006 to 2007 gives us a clear indication that the perception of counterparty risk had risen significantly. The spread between a 10-year treasury bill and an interest rate swap of a similar maturity went up from 47 bps in December 2006 to 66 bps in December 2007, peaking at 74 bps in November 2007, while the average monthly spread from December 2000 – December 2007 was a comparatively lower 54 bps!

10-year interest rate swap, 10-year Treasury bill and the resultant spread

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Source: US Federal Reserve

Bankruptcy – this time it is the municipalities

Increasing defaults in the housing market and reduced property values have dampened the outlook of the housing market. In addition, failure of big financial institutions and ratings downgrade of bond insurers have added to the intensity of the crisis. Rising foreclosures and lower property values on revaluation have reduced the local governments’ property taxes. Added to this, counterparty risk has increased from earlier years. All the above factors have led to the municipal bonds being subject to a significantly riskier environment than just a year before—the City of Vallejo, California is in a near bankruptcy state and similar talks are growing about Jefferson County, Alabama and municipalities in Florida.

With the entire state of California negatively affected by the current crisis, the City of Vallejo appears to be the most affected (see Vallejo in danger of declaring bankruptcy). The City of Vallejo, in February 2008, postponed a decision of declaring bankruptcy. Estimates say that currently, the city runs with a deficit of approximately US$10 million today, and is expected to grow over US$13 million at the end of FY 2009.

Jefferson County, on the other hand, took the beating from a failed credit derivative transaction. With the aim of financing a US$3.2 billion sewer cleanup, it resorted to interest-rate swaps with banks which underwrote that debt. The transaction imploded as circumstances in derivative markets deteriorated, leaving the county in a dire situation. See High Finance Backfires on Alabama County.

Future of municipal bonds and its affect on bond insurers

With almost 50% of the total municipal bonds in the US insured by the bond insurers, the downfall in the latter resulted in a significant negative impact on the municipal bond market. Municipal bonds were considered to be safer than most other fixed income securities in the market since they were government-related debt, yet they were also wrapped by monoline insurance contracts. As the ability to bear the liability of a bond declined (at least in the eyes of the capital markets), several bond insurers suffered downgrades by rating companies.

MBIA – Investment portfolio and insured portfolio (as of the end of 1Q 08)


Source: MBIA

Ambac, the nations 2nd largest and severely distressed bond insurer, reported similar figures to its larger counterpart, MBIA, in 1Q 08. Out of its total financial guarantees, the guarantees for public sector finance constitute 54.2%. In addition, out of its total fixed income investments, 73.2% are in municipal obligations. In the one year period from April 2008 - March 2009, Ambac expects its investment portfolio to generate a cash of US$807 million. This is significantly (and in my opinion, unrealistically) high, especially after Ambac reported negative revenues of US$1.5 million in 1Q 08 and had to exclude BIE’s and include short term security investments born from their recent share offering to quote positive investment income for the quarter.

Investment income excluding BIEs increased 7.9 million or 7% on increased volume driven by net positive cash flow from operations and to a lesser degree from the capital raise in March, which was primarily invested in short-term securities immediately after the closing. Now, let me focus on the credit issue that arose during the quarter. Our mortgage related exposures continue to drive the poor financial results. We have troubled mortgage exposures in three areas; financial guarantees of RMBS transactions, CDOs of asset backed securities, and to limit extent in our investment agreement, investment portfolio.”

In its 1Q 08 report, MBIA states that out of total insured portfolio of US$668 billion, 60% (or approximately US$438 billion) constitutes US public finance with most of it into GO bonds. Moreover, the company’s investment portfolio consists of approximately 55.5% of investments into the municipal bonds – highest across all categories. Going forward, it expects net investment income to constitute a significant portion of its revenue stream, from 2008 right up to 2017 with its contribution to total revenue increasing in all the years.

I asserted as early as last year that not only will these major mononlines get their lunch handed to them via their residential relate estate related housing exposure, but will also suffer from CMBS related exposure and rising muni distress. Because the level of diversification in this industry is de minimus, any stress in the muni sector will server magnify the horrors they are experience in the structured product and CDS markets.

Ambac – Investment portfolio and insured portfolio (as at end of 1Q 08)


Source: Ambac

These statistics indicate that in the future, investment income is expected to play a big part in bond insurers’ revenues. However, increasing defaults in the municipal bodies as a result of the ongoing crisis and higher risk in the municipal bond market are likely to significantly affect the performance of the monoline insurers, from both an operating perspective, investment income perspective and a widening of spreads both in their investment portfolio and on their own single name CDS. Also, many state and local governments have entered into credit derivative transactions which, although worked well in the bull phase, are taking a massive toll when the tides have turned.

Last modified on Wednesday, 14 May 2008 06:00