Mismanaged municipal and state governments around the country are finding a new target to blame for their own self-inflicted wounds: the growing market for credit defaults swaps (CDS) on municipal debt.
A municipal credit default swap would be a derivative that pays off in the event of default by a specific state or a default on one of said state’s debt instruments.
As reported in today’s Wall Street Journal, a handful of state treasurers are demanding information from Wall Street firms on who exactly is “betting against” these states.
It should come as no surprise, except to state officials, that the major buyers of these CDS are the very bondholders investing in their state. In fact the availability of municipal CDS will likely increase the demand for municipal debt. Just speaking for myself, there’s no way I’d buy debt issued by California if I couldn’t at least hedge some of that credit risk
Of course states complain that “betting on a default creates a perception of risk,” as if there wasn’t already a widespread perception of risk to investing in municipal debt of certain states. The states also express concern that adverse movements in the price of CDS could impact their credit ratings, and hence their cost of borrowing. Given the slow speed of which credit ratings moved on sub-prime mortgage debt, I am not sure that cities and states have much to worry about rating agencies being “too aggressive”. If these states had even a small understanding of how markets work, they’d understand the rating is just one element that goes into pricing. Witness the large spread in yields of similarly rated debt. No rating, or credit default swap price for that matter, is going to fool investors into believing that many American local and state governments are just anything other than mini versions of Greece.