Subprime Crisis Hits Municipal Bond Market
We can still remember when people were telling us that thesubprime crisis was confined to U.S. housing — that it was not a bigdeal in the final analysis. Well, the final analysis is not in yet,but oh were they wrong.
Not only is the subprime crisis not confined to U.S. housing— it is rippling through the entire U.S. and world economy. The FederalReserve, European Central Bank [ECB], and the Bank of Japan [BOJ] haveinjected liquidity . The ECB and BOJ have talked about deferringexpected short-term interest rate increases. The People’s Bank ofChina has been talking up the dollar in response the crisis.
One U.S. money market fund issuer has filed for bankruptcyand the large French insurer, AXA, had to infuse money to avoid“breaking a buck” on one of its money market funds.
The U.S subprime crisis is not just a U.S. housing problem,it is an overall problem for the U.S. and world economy. For a furtherexample, last week, the Bank of China (#2 bank in China) announced thatit holds $9.7 billion of U.S. subprime mortgage debt and has begunputting up new loss reserves for that. The reserves are only $152million so far, but when Chinese banks start having U.S. subprimeproblems, we’d say the problem is not domestic, is not contained and isnot likely fully revealed.
We’d like to add an anecdote from our firm’s direct experience to further illuminate the situation.
Last week, we managed the bid process for a municipal bond refinancing and the market information was astounding.
Ina municipal bond refinancing a city that has muni bond proceeds thatneed temporary investment prior to use will invest the bond proceeds togenerate income to pay the coupon on the muni bonds. One method — theone we were hired to manage — is to ask a major institution to providea guaranteed fixed return for a specified period for a particular sumof money, but with full flexibility for the municipality to withdrawfunds as may be required during the life of the guarantee. That iscalled a “flexible bond repurchase (repo) agreement”.
Normally, the bid manager (that’s us) would send a requestfor proposal to a significant number of large, high credit qualitybanking, insurance and investment banking institutions; and then sortthrough the responses, organize the data in a consistent way andrecommend to the municipality which to chose.
The selected repoissuer then puts Treasury securities in the amount of the guarantee inthe hands of a third party custodian, and the custodian passes the munibond proceeds to the repo issuer.
Normally, there is serious competition from institutions toget the business, but not last week. We sent proposal requests to 20major institutions that routinely do muni flexible repo business askingfor a 90 day repo for $20 million and a 1 year repo for another $20million. Of the 20 institutions only 3 submitted a proposal, while 17(85%) sent declinations. That level of non-availability isunprecedented.
The reasons given in the responses from the 85% that did notmake an offer were of two types: “We have no collateral available” or“We are not currently offering collateralized products.”
NO COLLATERAL! NO COLLATERALIZED PRODUCTS! Those twostatements represent a depletion of resources for new investment in thefirst case, and a general shift away from risk in the second case. Theproblem is popping up everywhere, and everybody is impacted.
