I’ve been saying this for months. At the end of the day, the financial health of many US States would compare to the financial health of Greece and other European Union countries having financial troubles. I may have been optimistic in my assumptions with the cost to insure the debt of some US States now exceeding the cost to insure the debt of some of these financially suspect countries. This from Bloomberg on August 21, 2010 (emphasis added):
Investors have to pay 284 basis points to insure their California bonds, 20 basis points more than for Portugal’s. At 298 basis points, Illinois is in worse shape than Ireland. It costs more to insure the debt of New York (224 basis points) than Italy’s.
Credit-default-swap spreads show that these U.S. states are “on the brink of financial catastrophe,” according to Justin Marlowe, an assistant professor at the Daniel J. Evans School of Public Affairs at the University of Washington in Seattle.
The headline-worthy spreads haven’t harmed these issuers in the bond market. They have reduced their cost of borrowing.
“Issuers benefit when investors have access to low-cost information that complements traditional credit ratings, even if that information suggests higher default risk,” Marlowe wrote in a recent study.
“My sense is this happens because high credit default swap spreads reassure investors that a low-management-quality issuer’s ‘dirty laundry’ has been aired in full,” he explained in an e-mail. “It’s counterintuitive, I know.”
Credit default swaps, common in corporate finance, have been used in the municipal market for only a few years. Issuers are grappling with an instrument created as a form of insurance that also may be used to place bets against them. California and Massachusetts earlier this year asked securities firms how they could underwrite their bonds and sell contracts that would allow investors to bet against the states in the same way they would short stocks.
Yes, you read that correctly. The States of California and Massachusetts asked securities firms to look into creating securities that would allow investors to bet ON these States defaulting upon their debt.
Just wait, the very same vehicles that helped cause the last financial meltdown may very well play a big part in the next meltdown. Here’s more from the Bloomberg article (highlighting once again added):
Speculators can buy a CDS contract without owning Illinois bonds, betting that the financial condition of the state will deteriorate and drive the price of default protection up to, let’s say, 500 basis points (the five-year credit-default-swap spread on Greece is 843 basis points). The speculator could sell the contract and pocket $202,000.
“Didn’t Financial Regulatory Reform address this?” you may be asking.
Sadly, no.
We’ll be keeping an eye on this and reporting back in this blog.
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