“Muni veterans are from Mars, Meredith Whitney is from Venus,” so says Lex, commenting on the wide divergence in current views about the future of the US municipal bond market. Whitney sees a coming wave of defaults; veterans see municipal debt/income ratios far below those that sovereign states routinely bear.
Lex frames the divergence as a matter of political judgment. Municipalities have made promises to bond investors, but they have also made promises to public sector unions in the form of wage and pension contracts. When the numbers do not add up, which promises will wind up being honored and which breached?
From a money view perspective, an alternative frame presents itself, namely the possibility of refinance. Quite apart from the possibility of public refinance, already we hear isolated stories of private refinance, which involve purchase of distressed municipal debt as a way of gaining control over the underlying assets, perhaps a hotel, or a stadium, or an airport.
This is the classic value investor’s game, which takes advantage of distress to buy assets below their fundamental value. All you need is a necessitous seller, such as a bond mutual fund that cannot hold downgraded securities, and an illiquid market. This is Warren Buffett’s game.
The new muni CDS market offers another, newer, way to play the game. In this game all you need is divergent views about the unknowable future. Martians sell CDS, Venusians buy CDS, and Wall Street dealers make money on the buy-sell spread.
But here is the rub.
In theory, the value of a credit default swap depends on the value of the underlying referenced asset; if the underlying bond falls in value, then buyers of CDS make money and sellers of CDS lose money. But in an illiquid market, the value of the underlying bond is hard to assess; if you really have to sell, you will probably have to sell at a fire-sale price.
In practice, therefore, the value of the underlying bond comes to depend on the value of the CDS, not the other way around. Martians and Venusians do side bets with one another, and the price of those bets sets the price of the underlying Earth-bound asset.
We’ve seen this game before, in CDS markets on Earth-bound mortgage securities, and more recently in CDS markets on sovereign debt securities. It is the price in the more liquid market that gets used whenever assets are “marked to market”, derivative markets tend to be more liquid than the underlying, and index derivatives tend to be more liquid than specific names.
So what is the problem? When Warren Buffett takes advantage of an illiquid market to buy real assets at a knockdown price, we admire him for his astute investment judgment. Why don’t we equally admire the Martians who take money away from the Venusians by selling them credit insurance when they are scared? In both cases, the business opportunity arises because market price deviates from fundamental value.
What explains the difference in attitudes about these two kinds of speculation?
I think the difference goes back to an old and fundamental debate about whether speculation is stabilizing or destabilizing. It seems pretty clear that Buffet’s speculation is stabilizing—he is stepping in as buyer for a necessitous seller, and without him the price would fall even farther. The case of the Martians and Venusians in the CDS market is less clear. Without them, there would be no CDS price volatility to drive activity in the cash market.
In October 1939, Nicholas Kaldor published a famous article “Speculation and Economic Stability” in the Review of Economic Studies. Riffing on a theme from Keynes, Kaldor advanced the argument that speculation could be destabilizing, in the sense that it pushes price away from fundamental value. To make matters worse, he argued, these price distortions can have real distorting effects on economic activity.
The worry, it is important to appreciate, is not just on the downside, but also on the upside. Prices can be too high (commodity prices?) as well as too low (municipal bond prices?), and they can be first too high (June 2007 MBS?) and then too low (January 2009 MBS?).
Kaldor was of course talking about a world, and a financial system, much simpler than our own. As we move to the derivative regulation phase of financial reform, we will face for ourselves the question he asked back in 1939. Speculation, stabilizing or destabilizing? For future reference, here is Kaldor’s answer (p. 10):
“Hence to our question: does speculation exert a price-stabilising influence, or the opposite? the most likely answer is that it is neither, or rather that it is both simultaneously. It is probable that in every market there is a certain range of price-oscillation within which speculation works in a destabilising direction while outside that range it has a stabilising effect. Where markets differ, is in the magnitude of this critical range of price-oscillation.”