Investors Rake in Cash by Shorting New Jersey

While regulators were sprinting to save the financial system last month, someone was making a lot of money — by betting against the State of New Jersey.

It is not clear who. But trading records suggest that in the panicked days when exotic derivatives were bringing the American International Group to its knees, traders were using the same kinds of derivatives, called credit-default swaps, to profit from New Jersey’s rising tide of red ink.

Speculators have long been able to short-sell stocks, making money when share prices fall. But derivatives are now making it possible, in effect, to short municipal bonds. If you think you are the first to determine that New York’s budget is going to suffer because of the financial crisis, then you, too, can wager on it.

The world of municipal finance has many hidden weak spots — the very playground of short traders — because governments are required to disclose far less about their finances than companies are.

“There are hedge funds that already, for at least a year, have been getting into this,” said Douglas A. Love, an economist and a member of New Jersey’s State Investment Council, which oversees the investment of that state’s pension fund. “It’s a sophisticated game and it has risks. But that’s the market.”

This form of market betting could force local governments to face up to long-simmering problems instead of sweeping them under the rug. But it could also increase the cost of raising money or, in an extreme case, drive investors away entirely if a city’s finances are perceived as shaky. Already, the housing slump has left some places struggling to balance their budgets as revenues dwindle and the credit crisis takes its toll.

Credit-default swaps are essentially a form of insurance. Bond investors can buy the swaps to protect themselves in case the issuer fails to pay its debt. But the swaps can also be used to speculate on the creditworthiness of an issuer, whether a company, a state or some other body of government, like a turnpike authority. The weaker its finances become, the more the value of the swap rises.

Investors can now bet on the creditworthiness not just of New Jersey, but also of Illinois, Texas, New York City and dozens of local government bodies, including the Triborough Bridge and Tunnel Authority and the Los Angeles Unified School District. The municipalities in play tend to be those that issue a large of number of bonds and are familiar to investors.

In the case of New Jersey, someone bought five years’ worth of default protection on the state’s debt in mid-July, on a day when the price edged to $41,000, from $40,000, for $10 million worth of bonds. (Traders do not have to own the bonds to buy the related swaps.) The price then floated up gently until mid-September, when suddenly Lehman Brothers declared bankruptcy, Merrill Lynch was sold and A.I.G. had to be bailed out by the Federal Reserve, all in the space of a few days.

Instantly, investors everywhere were risk averse, and the price of a five-year swap on New Jersey’s debt jumped to $84,000 for $10 million in bonds. For the buyer in mid-July, that is a jump in value of more than 100 percent in just two months.

Suresh Sundaresan, a professor of finance and economics at Columbia, cautioned against reading too much into such market movements. The municipal swaps market is thinly traded, he said, making it hard to know what forces are driving its ups and downs. In some places, a single big trade can affect the market.

Many traders are not speculators, he said, but insurance companies or other institutions buying protection for bonds they hold.

Still, he added, “if you have a notion about the underlying health of a municipality, and you think that this is eventually going to reveal itself to the market, then the simplest thing for you to do is go and buy a credit-default swap.”

Statistics on trading volume are not publicly available. But market sources said that swaps are traded to protect about $1 billion to $2 billion of municipal bonds each week, double the volume a year ago.

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The municipal bond market, meanwhile, has been reduced to gridlock in the last couple of weeks by the financial crisis. Even when the market returns to more normal conditions, state and local governments could face additional scrutiny because they share some of the characteristics now clouding financial institutions.

With great latitude in their accounting practices, poor enforcement of the rules and a big dose of actuarial science, some states and cities appear to be running big pension funds as opaque as the complex portfolios of mortgage-backed securities that now plague the nation’s banks.

“This kind of nontransparency is precisely what has landed us here” in the credit crisis, Mr. Sundaresan said. “If you’re not transparent, if you’re opaque, then in some sense, you’re borrowing money from the investing public without fully discharging your fiduciary duty. I’m very troubled by this.”

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