Tentacles of the Credit Beast

Posted by jeff

Mon Nov 19th, 2007 09:10 AM

tentacles.jpgOn Friday morning the Wall Street Journal pointed out that more money market funds are being hit by the sub-prime credit debacle and talked about troubles in municipal bond land - lets explore how the tentacles of the credit beast have ensnared both these areas. Now this story involves a little bit of esoterica so lets define some terms.

CDO = a collateralized debt obligation and it is an amalgam of low credit debt securities which when packaged together are supposed to have lower risk, these securities may have an insurance wrapper or guarantee from a bond insurance company backing them.

SIV = a structured investment vehicle. It essentially owns longer-term higher yielding paper that it funds with short-term lower yielding borrowings. It is technically a "spread arbitrage vehicle". What investors have recently learned is that banks set these funds up....and they didn't have to account for them as obligations on their balance sheets. They sold shares in the SIVs to investors (mostly hedge funds) and earned fees for managing them. Some of these funds held sub-prime related securities like CDOs and have had trouble borrowing short-term funds to support their holdings due to the credit crunch.

Bond Insurer = A bond insurer is an insurance company that sells a policy to a bond issuer or a company that creates bond-based products. The policy insures that if the bond or bond product has an unanticipated credit hit, the investor (owners) of the product will be protected to some extent. The policy is a cost to the issuer of the product or bond - but is basically passed along in some way to the buyer. It is a way for bond issuers to gain access to the investment grade market or for bond product producers to aggregate together lower quality credits and make a higher credit quality product. Rating agencies often get involved in requiring an issuer to get insurance if they hope to achieve a certain credit rating for the product.

Money Market Fund
= an ultra short-term bond fund. The portfolio of bonds turns over and is re-invested in new short term bonds within 30 days or so. Due to the short-term securities these funds hold, they tend to have very little interest rate or credit risk and tend to have yields that hew closely to short-term government bond returns, though a little bit higher because they don't hold risk free assets (hitherto known as US Treasuries). As a result of their low credit and interest rate risk and the fact that they pay out all their interest gains these funds tend not too trade very far away from a $1 unit value. These funds are therefore used by investors (like myself) to keep liquid assets in, above and beyond their FDIC insured bank accounts. For this reason the $1 value has been seen by investors and fund management companies as sacrosanct.

In past times of credit market crisis, fund companies have actually intervened to defend the $1 valuation level of a share of these funds and not allow them to "break the buck". Well its that time again. According to Business Week Online there have been 30 incidents this year in which fund management companies have intervened to prevent a fund from "breaking the buck". The reason these funds are having trouble, for the most part is not because they held subprime securities, but because they held short-term funding paper issued by SIVs which themselves held sub-prime paper and CDOs.

According to today's Wall Street Journal the fund companies involved in protecting their $1 unit value recently include such household names as Bank of America's Columbia Management Group, First American Funds, Credit Suisse Asset Management, Wachovia's Evergreen Investments, SEI Investments, SunTrust Bank and U.S. Bancorp's FAF Advisors.

Now according to Business Week there has only ever been one money market fund that "went bust" and investors got back 96 cents on each dollar. So nobody panic. However, it is concerning that funds regular folks depend on as essentially riskless are having some problems - it makes you wonder just how tangled a web has been weaved here. So lets tackle just one more curve ball.

Municipal Money Market Funds. Friday's Wall Street Journal discussed problems with bond insurers and the impact on municipal bonds as well. Municipalities and public institutions like hospitals use bonds to finance themselves and over the years, even those with lower credit ratings have been able to access capital markets easily by using bond insurers to help them attain investment grade status. These same bond insurers also insured CDOs and sub prime CMBSes and as a result of the sub-prime credit debacle stocks of the insurers like Ambac have gotten creamed this year. People are worried about how much of a hit they will take on the insurance they have written. As a result, municipal bonds backed by these same insurers are getting roughed up, raising the cost of new bond issuance by municipalities. You see this credit crunch keeps branching out and side swiping otherwise innocent bystanders. Thus far the wounds have not been particularly bad, but it has created an environment of risk aversion, which makes sense, but also raises the cost of doing business for most participants in the economy.

The chart below shows the divergent performance between bonds in general and municipal bonds in recent weeks as the street started to worry about municipal bond insurers ability to pay out claims. Specifically, the chart shows the Lehman Muni Bond Index vs. Lehman Aggregate Bond Index (notice the widening of the spread since mid October!):


What This Chart Means: It means tighter money for a less than investment grade municipality (state & local govt's, hospitals, infrastructure, bridges, tunnels, services, roads)! Municipal bond prices (presumably those with "credit enhancement" or bond insurance backing their ratings) are under pressure due to worries about the insurers' ability to pay out claims. This concern raises the cost of borrowing for these lower rated borrowers, and is just another example of the market spread between high credit worth borrowers and others rising. Note that this comes when the tax base of many municipalities is being hurt by lower numbers of real estate transactions - which the market may also be factoring in.

I got the bright idea this summer of not keeping all my cash reserves in bank accounts when an unknown amount of sub prime damage was about to come crashing down on money center banks. I was also worried about moving all the funds to a money market fund which could have some issues with the sub-prime mess. So thinking I was a savvy - though obviously overly paranoid - guy. I moved a bunch of money into a Municipal Money Market Fund. This is a fund that owns short-term municipal securities and acts just like a money market fund, but it also has the advantage of being federal and state tax free. This morning I'm wondering what, if any, exposure I have to the credit mess with my Muni Money Market Fund. Don't call to ask me any questions on this article..... I'm on hold with Fidelity. But seriously, I'm not really too worried, but there is a point here. This credit mess has more angles than a Tiger Woods birdy putt. Its very hard to know what and how big the fall-out will be and whether the wide disbursement of risk made possible by so many new financial products, derivatives and investment funds is a great thing or means that an eventual all out credit crisis (which happens every so often like it or not) will be even worse when it does come.

Oh what a tangled web we weave!

P.S. For any one who does own muni bond funds, I stumbled across another issue that could become a concern....bad luck sure clusters - check this Supreme Court Case on State Tax Powers out.

From the Blogosphere:

Money-Market Funds: A Safety Check (BusinessWeek)

Will Your Money Market Fund "Break the Buck" (Washington Post)

Money Market Funds at Risk? (CNBC)

How-to-tell-whether-to-move-out-of-your-money-market-fund (Blogging Stocks)

Municipal Bond Insurers: More Dangerous than you realize (Accrued Interest)

Good Summary of How the Bond Insurance Business Works (Common Sense Forecaster)