Dec. 10 (Bloomberg) -- Goldman Sachs Group Inc., one of the top five U.S. municipal bond underwriters, is angering politicians and public-finance officials in New Jersey, Wisconsin, California and Florida by recommending that investors purchase credit-default swaps to bet against 11 states’ debt.
In the three months since the New York-based securities firm recommended “shorting municipal credit,” the value of the Markit MCDX index of the derivatives’ price more than tripled, to as high as 278.33 basis points from 87.75. A basis point on a credit-default swap protecting $10 million of debt for five years is equivalent to $1,000 annually.
Bets against public debt, once unheard of on bonds considered safe enough for retirees, have soared as the National Conference of State Legislaturesprojects recession-fueled budget crises will cause $97 billion of shortfalls nationwide over the next 18 to 24 months.
It’s “disturbing” to advise investors to bet against the financial health of a state whose bonds Goldman helps sell, Assemblyman Gary S. Schaer, a Democrat who chairs the Financial Institutions and Insurance Committee, said last week in a letter to Chief Executive Officer Lloyd C. Blankfein.
“New Jersey needs to maximize its presence in the credit markets, not to see its presence undermined.” Schaer wrote.
Goldman responded on Dec. 5, said Andrew Schwab, a spokesman for Schaer. The assemblyman was discussing the firm’s letter with state Treasurer David Rousseau, he said. Michael DuVally, a Goldman spokesman, declined to comment.
‘A New Reality’
Short sellers borrow securities to sell, betting their value will decrease. Credit-default swaps, conceived to protect bondholders against default, pay a buyer face value in exchange for the underlying securities or the cash equivalent should an issuer fail to adhere to debt agreements. They increase in value as perceptions of credit quality deteriorate.
“Shorting municipal bonds -- the world is a new place,” said Patrick Born, chief financial officer for the city of Minneapolis. “There’s a new reality, at least for a while.”
The appreciation in municipal credit default swaps came as borrowing costs rose, with tax-exempt yields as measured by the Bond Buyer 20-bond index reaching 6.01 percent on Oct. 16, the highest since January, 2000. The index is now 5.58%.
Though familiar in corporate finance, credit-default swaps had been largely absent from the $2.7 trillion tax-exempt bond market. Trading grew this year as the biggest municipal bond insurers lost their AAA ratings and the MCDX index, tied to 50 municipal issuers, was started in May.
Secondary Market
The spread on 10-year California swaps widened to 289 basis points yesterday from 93 basis points in mid-September, according to data compiled by Bloomberg. Investors who sold their contracts could have pocketed $196,000. A basis point is equivalent to 0.01 percentage point.
While the Depository Trust & Clearing Corp. said $3.6 billion worth of MCDX contracts were registered in a central trade warehouse as of Nov. 28, definitive data on the size of the over-the-counter swaps market for municipal bonds are unavailable. The Bond Buyer newspaper estimated its size at $250 billion on Nov. 21. The market for the derivatives on all bonds was estimated at $47 trillion in October by the International Swap Dealers Association.
Volume in municipal credit-default swaps may not be large enough yet for traders to sell when they want, said Jon Schotz, a partner at Saybrook Capital Management in Santa Monica, California. The firm oversees $460 million of municipal debt.
Advice Draws Criticism
“I can pick five different numbers, and I don’t have confidence in any of them,” Schotz said. “The sell-side is trying to convince a buyer of CDS that there is an active and robust secondary market if one wants to exit. That is a very tough sell today.”
New York-based Morgan Stanley has also recommended using swaps to bet against state credit. While Merrill Lynch recommends the derivatives to “institutions who want a vehicle to express relative value views,” Phil Fischer, a vice president of municipal strategy at the firm, said many are “thinly traded.”
Merrill is the second-leading underwriter in municipal bonds this year, with 329 deals totaling $39 billion, and Morgan Stanley is fourth, with 292 issues worth $31.2 billion, according to Thomson Reuters.
Yet it’s Goldman’s advice that has drawn criticism, after news articles about it last month by ProPublica, a New York-based nonprofit organization specializing in investigative reporting, as well as the Los Angeles Times and The Star-Ledger of Newark, New Jersey.
Underwriter’s Role
As part of a September presentation to institutional investors on “Best Long and Short Risk Strategies,” Goldman recommended buying credit-default swaps on “a basket of liquid State General Obligation credits with current and worsening fiscal outlooks,” including California, Florida, Nevada, Ohio, Wisconsin and Michigan.
The firm also recommended the derivatives on states with “significant unfunded pension” and other retiree obligations, including Illinois, Connecticut, Hawaii, New Jersey, Massachusetts and Nevada.
The practice of betting against such states is “distasteful,” said Frank Hoadley, Wisconsin’s director of capital finance in Madison.
Goldman ranks fifth as a managing underwriter of municipal bonds this year, handling 222 deals totaling $29.7 billion for an 8.2 percent market share. The firm has acted as lead managing underwriter in all the states it recommended betting against, except Hawaii.
Not Surprised
“Are you really surprised?” said J. Ben Watkins, Florida’s director of bond finance. “It’s dealers talking out of both sides of their mouths.”
New Jersey’s Schaer said in an interview he wasn’t certain Goldman’s pitch would increase the state’s cost of borrowing. Wisconsin’s Hoadley said he doubted much effect -- though this year’s credit crunch makes it difficult to attribute much effect to credit-default swaps.
“In this market, how can you tell?” he asked.
To contact the reporter on this story: Joe Mysak in New York atjmysakjr@bloomberg.net.
