Is The Sleepy Muni Credit-Default Swap Space Coming Back To Life?

Warren Buffett and Berkshire Hathaway recently announced that they closed out a very large bet that they had which insured a big amount of municipal debt from default. The move that they made brought a lot of attention to a market that has basically been sleeping for quite some time.

Market watchers say that a lack of liquidy is a major concern and a big potential for defaults, as well as spreads in the $60 billion municipal credit default swap market are also wide and they have been for quite some time now.

The Berkshire Hathaway trade obviously sounds technical, and there was a recent move in the industry to standardize contracts which could very well increase the interest in muni credit default swaps. This area has suffered from apathy by many investors, and it has also suffered from a lack of volatility and price with the active traders.

There are many people in this industry who have noted that Berkshire’s move should not be looked upon as pessimism from Warren Buffett in regards to the municipal bond market. Headline risk has unfortunately increased due to some municipal bankruptcies that were very high profile, as well as the predictions that there are going to be more bond defaults in the future. But it’s not surprising that such a big transaction would bring a lot of attention to the municipal credit default swaps market, said Mikhail Foux, who is a municipal analyst at Citi.

“It could help the liquidity of muni CDS,” he stated. “There could be no effect. But if there’s going to be a positive effect, we’re going to see it in the fall, when people realize that the technical is not there anymore. Spreads are still cheap; fundamentals of the space are still pretty good, with certain exceptions. Why wouldn’t you take some exposure?”

Spreads of municipal credit default swaps have skyrocketed over the last few years. Just recently as of early September, the Markit benchmark 10 year muni CDS index spreads (MCDX) actually rose a total of 167 basis points to reach 215. This is from its inception in May of 2008, when the spread was only 48 basis points.

The initial widening of the municipal credit default swap spreads took place in 2009. They also went up again in 2010, and this was because of the credit concerns in regards to the municipal bonds which never actually materialized. But the spreads have yet to tighten.

Since the actual MCDX numbers are representative of the cost of buying protection against default, it is not surprising that higher spreads mean that it’s going to be a lot more expensive to get this protection. As an example, a 250 basis point spread for a state credit default swap means it would run you around $250,000 per year to obtain protection on a $10 million notational amount of the debt of that state.

The deal that Berkshire Hathaway had involved over 13% of the municipal credit default swap market, and upward of 30% of the single-name sub-group therein, which was estimated by Foux.

In 2007, Lehman Brothers had bought $8.25 billion worth of single name municipal credit default swaps from a Berkshire Hathaway subsidiary. This covered the general debt obligation which was issued by 14 states. Because the number of contracts was so large, as well as the relative illiquidity of the single name municipal credit default swap market, Lehman Brothers could not make any kind of money when trading them.

Somehow they managed to unwind the credit default swap with Berkshire Hathaway. The company announced during the second quarter when they filed that it had actually terminated their municipal and state CDS contracts, and most likely lost money on this transaction, which we learn by somebody who is on the inside and familiar to the deal that was made.

Berkshire is still exposed to this market by roughly $8 billion, and this is through local and state credit exposure due to other insurance agreements that are already existing.

The municipal credit default swap market has actually been quiet for quite some time now. This is basically because of all of the relative illiquidity, which we learned from a municipal bond analyst in New York.

For starters, the municipal credit default swap market isn’t actually very deep, and there are only a few brokers quoting them, according to the New York analyst. It’s also true that they aren’t widely utilized because real money buyer’s really don’t have a lot of interest in this product at this time.

The analyst also said that “there is a really limited global macro audience, which is effectively what this market would need.”

There is even a tax consequence involved with muni CDS. Investors are always going to have to pay taxes on any trade that results in a gain, according to our New York analyst.

“A lot of funds and traditional munis, you can’t do that inside the prospectus,” said the analyst. “So, you’re left with a bit of illiquid market.”

Lately there has been a lot more interest with trades in the MCDX, even though activity has slowed down quite a bit. The interest is a lot more than there is in individual muni CDS names. We learned this from John Hallacy, who is a strategist for municipal research at Bank of America Merrill Lynch.

The municipal credit default swap liquidity could actually continue to increase for quite a few reasons, noted Foux. For starters, earlier this year the International Swaps and Derivatives Association put forth a new rule that aligned the muni bond CDS market with those that exist already for corporates and sovereigns, which makes the muni CDS less risky and a lot more efficient for investors.

This new rule also included brand-new auctions – settlement terms, a common standard effective date for municipal credit default swap transactions, as well as a resolution committee.

So far the market watchers do not agree on the amount of which the changes have affected this market. “Ironically, when they made that move to standardize the contracts several months back, they thought it would increase activity. But it seems to have had the opposite effect,” said Hallacy.

Otis C. Casey 3d, who is the current director of credit research at Markit, recently said that the move by the industry to standardize US municipal CDS contracts actually had a positive effect on the market already. “There was a noticeable increase in liquidity immediately following the changes in the Markit MCDX index, for example,” he stated.

Municipal credit default swaps currently remain very cheap if you compare them to the high-grade corporates and sovereigns, according to Foux from Citi. So when you think about it, municipal credit default swaps can actually be looked upon as a real opportunity.

I also want to point out that the lack of liquidity, and not faulty fundamentals, is the main reason why we are seeing wider municipal credit default swap spreads, we learned from Foux. He also added that if the liquidity improves, the spreads would most likely tighten up and present investors with the opening that they need to go long. It all boils down to getting the timing right.

Casey said he is not certain if Buffett’s involvement in municipal credit default swaps provided any “notoriety benefit,” but he is still very confident in the health of this market.

“It goes without saying that sound technicals help liquidity in the market for any financial instrument,” he stated.

According to our New York based municipal analyst, it is going to take a major selloff in muni yields to the tune of roughly 75 to 100 basis points in order to bring more investors into the municipal credit default swap arena.

“If we backed up in a violent move, you might see different players then get involved in the market because they think they could strip out some total return,” he stated. “But the way the market is currently, with its lack of volatility and supply – demand imbalance, it doesn’t lead a lot of people into that type of trade.”

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