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Monday, 18 February 2008

Weekly Report 18th February 2008

The Collection Agency – Weekly Report

18th February 2008

Welcome to the weekly report. As another bond market fails due to a dearth of buyers and a lack of support from Market Makers, I want to have a look at the inner workings to see who is displaying signs of distress. Is the Municipal Bond market the right place for investment and have PIMCO and SIFMA unintentionally pointed out the pitfalls?

First up though is Bear Stearns whose shares and call options leapt up on Friday (15th).

An unconfirmed buyout rumour circulated the markets during Friday causing a 5.5% jump in Bears shares to $82.79 with 20 million shares traded, the highest volume since August last year. Call option volume was high too with more than 80,000 contracts traded. Someone made a killing on this rumour. The rumoured buyout price is around $98, with the offer supposedly in cash. However by digging a little deeper the possible real reason for the unconfirmed rumour becomes clearer.

According to Reuters via Bloomberg: “China's government-controlled Citic Securities Co., which agreed in October to pay $1 billion for a 6 percent stake in Bear, is renegotiating to get a 9.9 percent stake because of the decline in the company's shares since then, Reuters reported yesterday, citing two people with knowledge of the talks whom it didn't identify. Bear shares lost 33 percent of their value since the original Citic agreement through yesterday. Citic is still seeking to invest $1 billion in the company, Reuters reported.”

Without alluding to a conspiracy theory, the rumour does seem rather well timed. Let us say, just for arguments sake, someone is intent on ensuring that only 6% of Bear is up for sale. To achieve that target the share price would need to recover to the October level.

A look at the Bear chart for the past 6 months (Bloomberg) reveals some interesting points:

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It has some nice support with volume in January and late September last year. For those that like gaps in price action we have gaps at approximately $90, $100, $112 and - yes you guessed it - at the high in October ’07. We may not fill all the gaps but I wouldn’t be surprised if 3 out of 4 did. As usual, I have no position in Bear and I am not recommending one be taken.

For those that read my Occasional Letters, the contagion in the credit markets comes as no surprise, indeed I have been writing about it for long enough that some may think its “old hat”. I hope so, it means I did my job well. This week saw a continuation of the breakdown in the Auction-Bond system, where Municipal Bonds are auctioned off by banks acting as market makers. The problem is simple buyers are not showing up, driving muni bond prices down and yields up. This is not a new event, it has happened before but previously the banks stepped in and provided support by buying using their own money.

Not anymore. The capital resources of major banks are no longer available to ensure the smooth running of the Municipal bond auctions. The money it seems is needed elsewhere. Don’t forget, these Muni bonds are not junk, they are highly rated with yields that reflected their status. We are not talking about banks being risk adverse (unless…..) this is about banks no longer having capital to support a safe market. Be warned.

If the Banks blame the auction failures on the downgrades of the Monoline Insurers, which is threatening the rating and safety of the muni bonds, think of the excuse as more of a propaganda tool.

Even in the failed auctions the yields on most bonds didn’t hit the headlined 20%. Most rose to the 5-6% area. You would have thought that should make easy profits for the market making banks if they picked up the muni’s at the lows. It would seem that the banks can’t even afford to bottom pick.

The fallout in the economy if this continues will be of great importance. Local Governments, Authorities, Hospitals, Schools etc will either have to pay greatly increased yields to bond buyers or buy the debt back. Either measure will cost those who have to pay taxes or fees. Yes, that you. Of course, the bond sellers could always default if the payment of the high yield becomes too much to bear. I suspect the calls for a full-scale bailout maybe louder and earlier than those made for the sub-prime crash.

As an aside, so far since the “credit crunch” arrived, the Commercial Paper, Asset Backed Commercial Paper, MBS, CDO, CDS, Covered Bonds (Europe) and LBO markets have all suffered dislocation or an actual closure or failure. Do not forget which Federal Reserve, Government, Treasury, Brokerage, CEOs or Analyst spokespersons told you this was a contained problem that would not spillover into the economy. Remember not to trust them again.

Let us spend a few minutes looking at which banks act as market makers in the Muni bond auctions. Of course, I am not saying that they maybe in trouble but it does worry me that they have no capacity left to help credit markets, or at least, they are no longer willing to make markets. Hands up those who think such a problem will remain contained to the Muni auctions? No hands…..You are all very bright…

Listed in no particular order are the banks associated with failed Muni bond auctions, with charts from Bloomberg:


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Goldman Sachs:

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Lehman Brothers:

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So far I have only seen reference to the above broker/bankers in relation to Auction failures and the lack of support. I suspect there are more.

You may well ask if there is a way that the troubles in the Muni bond market could be speculated upon? There is an instrument but I have reservations about it’s use.

Lehman Bros have an ETF (ITM) for municipal bond markets, however it is illiquid and thinly traded. It was first marketed in November last year, so data for the ETF is scarce. The timing of the introduction of ITM may just be a coincidence but I’m not so sure, it could be viewed as an attempt to increase liquidity, allowing Banks to expand hedging strategies.


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Finally I want to look at the dynamics of the municipal bond market. According to SIFMA:

“The municipal bond market is one of the world’s largest and most remarkable securities markets. Approximately $1.7 trillion worth of municipal bonds are currently in the hands of investors. There are more than 50,000 state and local entities which issue municipal securities, and 2 million separate bond issues outstanding.”

This is a large market to which many are exposed. Indeed it has a high number of private individual participation, either directly or through Funds. As SIFMA states:

“An estimated 5.1 million households own municipal bonds in some form—either through direct ownership of individual bonds or through investment in institutional portfolios, including mutual funds, unit investment trusts, and bank trust accounts, according to the most recent figures available from the Internal Revenue Service. Commercial banks and insurance companies are also major institutional holders of municipal bonds.”

Is there anything to worry over? Well frankly yes there is. Once again we have to remember that this market is reliant on high quality ratings given by the Rating Agencies to achieve it’s standing in the investment world. Whilst part of that rating is awarded on the credit quality of the bond issuer the larger emphasis is placed on the default protection granted by the Monoline Insurers.

Interestingly the low volatility of the Municipal Bond market is seen as a good point, not only by SIFMA but also by PIMCO. SIFMA like to point out that most individual investors buy and hold until bond maturity whilst PIMCO have this to say:

“Historically, returns on municipal bonds tend to be less volatile than those on other asset classes, from equities to long-term Treasuries…….One reason for the lower volatility: individuals are the main investors in the municipal bond market and in general do not actively trade the bonds. Retail investors tend to buy and hold muni bonds to maturity. This contrasts with many other fixed-income sectors where institutional investors dominate. Individuals comprise more than 70% of the municipal bond investor base. Property and casualty insurance companies are the next largest set of investors at around 14%. The remaining investors are banks and corporations.”

In other words, this is a market utterly dependent on the continued confidence of the private investor. Low volatility in a stable or rising market can be beneficial and would not be affected by illiquidity but that changes dramatically in a market panic.

Can this market continue to rely on private investor apathy? I doubt it and so do the banks.

We can see why the banks have withdrawn support. If yields continue to rise as a lack of buyers force bond prices down then the risk of a possible default event is heightened. Combine that with a complete lack of faith in the Monoline Insurers ability to cover such an event and the municipal bond market doesn’t look such a sure fire winner.

How will private investors react to a default event in the municipal bond market? Human nature being what it is coupled with an elevated awareness to credit and bond market disruptions will ensure an attempt at a mass exodus.

That is highly unlikely to be an orderly exit. PIMCO has this to say in the conclusion to “Municipal Bonds: A Unique Fixed Income Asset Class”:

“In addition to their tax-exempt status, muni bonds may offer several advantages, including: higher after-tax returns than many other taxable bonds, high credit quality, and relatively low volatility. While institutional investors dominate the investor base in most fixed income sectors, retail investors form the biggest investor base in the municipal bond market.”

At one time that probably sounded attractive to investors. A re-reading will have more than a few investors (and PIMCO?) looking nervously at their portfolios.

1 comment:

Anonymous said...

The muni-bond market is almost unique then amongst markets - private investors matter?

As many know I get rather fed up by the trade press (Financial Times, etc.) referring to "investors" selling or buying this or that, they don't, "traders" employed by large organisations to play with ordinary people's money do. Of course they present that as private investor purchases, sales, redemptions or whatever else in order to cover the fact that actually they do a pretty awful job of looking after clients ....