The Volokh Conspiracy - Risk Shifting that Might Turn Out Not to Shift Risk?

The WSJ money and finance page had a story on Monday, June 15, 2009, about the return of an old financial product in new clothing for the municipal bond market. That market has suffered as concerns about municipal and state finances grows while concerns about the guarantors, explicit and implicit, by banks and financial institutions, has grown even faster. The problem has always been one of borrowers wanting to borrow for the long term but paying short term rates:

Much like auction-rate, variable-rate, and corporate floating-rate debt, the new tax-free "Windows" or "X-tender" securities offer municipalities the ability to borrow for the long term while paying only short-term interest rates.

This model proved dangerous during the credit crisis. Banks and bond insurers -- who offered both express and tacit guarantees to backstop the debt -- failed to live up to some of their promises. These securities became untradeable and dropped in value, leaving money-market funds in jeopardy of "breaking the buck." Borrowers like municipalities, nonprofit institutions and student-lending companies faced penalizing interest rates well over 10% for months.

Let me say that the idea that money-market funds could actually be riskier than federally insured depositary accounts certainly gave me pause - though obviously it should not have, since every statement for my money market fund said explicitly not insured by the FDIC, but I treated it as all interchangeable, risk-wise, and the Federal government quickly stepped up to the plate and covered my exercise in moral hazard, and yours. The lesson that Wall Street seems to have absorbed is that the banks and bond-insurers didn't pay off as planned, or were at risk of doing so, and therein lies the source of potential trouble. So the new (old) instruments shift the risk onto the municipal issuers directly:

Like auction-rate securities and other variable-rate debt, the new instruments have an interest rate that resets every week, but this one is based on a short-term municipal debt index. The securities act like short-term debt and are appealing to money market funds that need to be able to sell their investments quickly.

This time, though, the banks removed some of the weak links from auction-rate securities and variable-rate demand bonds. Instead of banks or bond insurers acting as a guarantor or buyer of last resort at the auctions -- which they were increasingly forced to do last year -- the borrower itself promises to accelerate repayment. The borrower has seven months to repay.

The question, of course, is whether this structure is stronger or weaker than the one it replaces. It addresses institutions that failed, or were at plain risk of failing, to meet their promises explicit and implicit. But does anyone think that the true problem for investors is solved by putting the burden onto municipal issuers? This is so obvious a point that I wonder if there is not a political, rather than economic, motivation behind it - the assumption that the Federal government serve as the guarantor of last resort if or when local governments and states begin defaulting:

That structure puts greater risks on the back of the borrower, which needs to come up with the money to repay bonds. The risks also flow to money-market funds, which must be able to easily sell holdings in order to keep each share at $1 at all times.

Despite the risks, the Securities and Exchange Commission blessed the instruments, allowing money-market funds to buy the debt.

Banks are also taking advantage of pent-up demand from municipalities that need money. Outstanding issuance of variable-rate debt has shrunk by approximately $100 billion in 2008 -- a 20% drop, according to Municipal Market Advisors. The banks are now estimating as much as $10 billion in such "Windows" deals could hit the market over the next six months. So far, at least two municipalities have sold the debt and another deal is close to completion.

Some fund managers aren't convinced. Steven Permut, senior vice president at American Century Investments, which has a pair of tax-free money-market funds, said he was "uncomfortable" with the product as proposed, because it would expose his funds directly to the risk that an issuer didn't have adequate cash to refinance in difficult market conditions.

I'm with Permut on the risks here. It's not just California; it's all those local government entities, too, in places you've never heard of. But given the demand for municipal financing, the increased expense of bank bond guarantees and the questions about them, but also the mounds of cash sitting in the funds in a world of super-low short term rates:

"The money funds are being forced into being more aggressive," said MMA managing director Matt Fabian.

With short-term interest rates at historical lows, funds are reaching to riskier products for higher yields. "They've become increasingly liberal in the structures they will accept because they're sitting on so much cash," said Mr. Fabian.

	[Kenneth Anderson, June 16, 2009 at 10:42am] Trackbacks Risk Shifting that Might Turn Out Not to Shift Risk? The WSJ money and finance page had a story on Monday, June 15, 2009, about the return of an old financial product in new clothing for the municipal bond market. That market has suffered as concerns about municipal and state finances grows while concerns about the guarantors, explicit and implicit, by banks and financial institutions, has grown even faster. The problem has always been one of borrowers wanting to borrow for the long term but paying short term rates: Much like auction-rate, variable-rate, and corporate floating-rate debt, the new tax-free "Windows" or "X-tender" securities offer municipalities the ability to borrow for the long term while paying only short-term interest rates. This model proved dangerous during the credit crisis. Banks and bond insurers -- who offered both express and tacit guarantees to backstop the debt -- failed to live up to some of their promises. These securities became untradeable and dropped in value, leaving money-market funds in jeopardy of "breaking the buck." Borrowers like municipalities, nonprofit institutions and student-lending companies faced penalizing interest rates well over 10% for months. Let me say that the idea that money-market funds could actually be riskier than federally insured depositary accounts certainly gave me pause - though obviously it should not have, since every statement for my money market fund said explicitly not insured by the FDIC, but I treated it as all interchangeable, risk-wise, and the Federal government quickly stepped up to the plate and covered my exercise in moral hazard, and yours. The lesson that Wall Street seems to have absorbed is that the banks and bond-insurers didn't pay off as planned, or were at risk of doing so, and therein lies the source of potential trouble. So the new (old) instruments shift the risk onto the municipal issuers directly: Like auction-rate securities and other variable-rate debt, the new instruments have an interest rate that resets every week, but this one is based on a short-term municipal debt index. The securities act like short-term debt and are appealing to money market funds that need to be able to sell their investments quickly. This time, though, the banks removed some of the weak links from auction-rate securities and variable-rate demand bonds. Instead of banks or bond insurers acting as a guarantor or buyer of last resort at the auctions -- which they were increasingly forced to do last year -- the borrower itself promises to accelerate repayment. The borrower has seven months to repay. The question, of course, is whether this structure is stronger or weaker than the one it replaces. It addresses institutions that failed, or were at plain risk of failing, to meet their promises explicit and implicit. But does anyone think that the true problem for investors is solved by putting the burden onto municipal issuers? This is so obvious a point that I wonder if there is not a political, rather than economic, motivation behind it - the assumption that the Federal government serve as the guarantor of last resort if or when local governments and states begin defaulting: That structure puts greater risks on the back of the borrower, which needs to come up with the money to repay bonds. The risks also flow to money-market funds, which must be able to easily sell holdings in order to keep each share at $1 at all times. Despite the risks, the Securities and Exchange Commission blessed the instruments, allowing money-market funds to buy the debt. Banks are also taking advantage of pent-up demand from municipalities that need money. Outstanding issuance of variable-rate debt has shrunk by approximately $100 billion in 2008 -- a 20% drop, according to Municipal Market Advisors. The banks are now estimating as much as $10 billion in such "Windows" deals could hit the market over the next six months. So far, at least two municipalities have sold the debt and another deal is close to completion. Some fund managers aren't convinced. Steven Permut, senior vice president at American Century Investments, which has a pair of tax-free money-market funds, said he was "uncomfortable" with the product as proposed, because it would expose his funds directly to the risk that an issuer didn't have adequate cash to refinance in difficult market conditions. I'm with Permut on the risks here. It's not just California; it's all those local government entities, too, in places you've never heard of. But given the demand for municipal financing, the increased expense of bank bond guarantees and the questions about them, but also the mounds of cash sitting in the funds in a world of super-low short term rates: "The money funds are being forced into being more aggressive," said MMA managing director Matt Fabian. With short-term interest rates at historical lows, funds are reaching to riskier products for higher yields. "They've become increasingly liberal in the structures they will accept because they're sitting on so much cash," said Mr. Fabian.