Municipal Market CDS – ♪ Somebody call 9-1-1…Fire burning in the muni market ♬ (Part 3)

Part 3: The Swaps is continued from Part 2: The Problems

The CDS reaction

According to Otis Casey at Markit in a DerivativesWeek report (before news of the Harrisburg state bailout was known),

“Some market participants have noted that the fiscal challenges facing municipal issuers are not too much unlike the challenges facing the high beta sovereigns in the European market. In fact, CDS spreads on the small universe of municipal credits with traded CDS tend to widen out when the markets refocus on the sovereign debt problem. However, there is no liquid market traded for municipal CDS on Harrisburg, Pennsylvania and the impact of this default is expected to have a small impact on the municipal bond markets, at least for now. CDS on the Commonwealth of Pennsylvania did widen though by 13 basis points on Wednesday [Sept. 1, 2010] to 134 bps in reaction to news on the chance that the state may have other municipalities struggling with similar problems and may have to offer direct financial aid to Harrisburg. So far it has not done so.

The real impact of this default may not be felt broadly in the financial markets now, not even in the nascent municipal CDS market but the default does have some symbolic significance. Just maybe it sets a precedent for other issuers to follow suit.

Commonwealth of Pennsylvania credit default swaps (‘Penn CDS’, the closest trading instrument that can be used to trade this event) were at the 120 basis point level at the end of August (just before the first announcement that the city intended to skip). At the time, those levels were close to the CDS levels of the Commonwealth of Massachusetts CDS at 125 basis points (yes, Pennsylvania and Massachusetts are both commonwealths and not technically states by legal definition)  and about 20 basis points tighter than Ohio State CDS. Those states are currently in the middle of the pack in terms of credit risk as measured by muni CDS price for the score of municipal CDS names tied directly to GO debt. Delaware is currently seen as the least risky municipal (state) with a CDS price of around 55 basis points.

On the other end of the scale, Penn CDS are still far away from the most risky municipals – a title that has bounced between California, Illinois State and Sicily (in Italy). California CDS is currently around the 280 basis point level according to CMA and around the 253 basis point level according to Markit via Thomson Reuters with Illinois in the same general vicinity (CMA quotes Illinois slightly lower while Markit quotes Illinois slightly higher). At that price level, it implies a default probability of over 20%.

According to the most recent quotes (Sept. 22, 2010), Penn CDS is back at its end-of-August levels of around 121 basis points, though still up about 8 basis points from last week. Pennsylvania CDS is currently a member of the MCDX municipal credit default swap index and, over the past week, was the third-largest widener after Massachusetts and the Massachusetts Bay Transportation Authority (MBTA, Boston’s transportation system, see chart below).  The MCDX index itself, however, has not reacted that significantly over the past couple weeks and has not moved much since an active late-spring/early summer (see graph below or the earlier CreditLime story).

Related CDS

Another name that has felt the impact of these events is bond insurance company Ambac Financial Group, whose subsidiary Ambac Assurance had insured the Harrisburg GO debt that was in question. Had the city failed to come up with the money to pay, the bond insurer had already said it would cover its promise so investors wouldn’t have actually been left to dry. But the long-term fate of Ambac itself is also in question as critics wonder whether the company can survive the losses sustained from insuring risky (non-municipal) securities in past years. Swaps on the insurer are reflective of this with 5-year Ambac CDS rising  half-a-point to a point to 72 points upfront (plus 500 basis points running) on the initial news that Harrisburg was going to skip its payment and leave Ambac responsible for making it.

To the insurer’s luck, Harrisburg ended up being able to make the payment but avoiding a few million on a single municipal issue is definitely not near the billions-of-dollars worth of bigger problems it has and is unlikely to move the company’s CDS in any meaningful direction. Penn CDS, on the other hand saw a much bigger reaction with prices rising  18 basis points on the Tuesday following the bailout. The worries now are whether other municipalities in difficulties – Pennsylvania or other states – will look to the Harrisburg example as precedent and try their own shenanigans to draw/lure/coerce/force state funds into local coffers and be bailed out themselves – effectively unloading city and county credit risk onto the state (sound familiar…think back to the European sovereign and banking situation).

For more…

Reuters has a good summary of the pre-summer Harrisburg situation (up until May 2010). While perhaps a bit lengthy, if you actually got down to reading this far then you may actually be interested enough in the topic to keep on reading.

Otherwise we invite you to have a look at the wonderful residents of Harrisburg and submit your funny comments as to why these people all still have smiles on their faces while their elected officials are crying foul.

This report is part of a 3-part series covering the financial difficulties in Harrisburg and municipal CDS.

Part 1: The Background

Part 2: The Problems

Part 3: The Swaps (current)

Chart and Graph Source: Markit. Platform: Thomson Reuters



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