Investors Rake in Cash by Shorting New Jersey

Like some others, he thinks traders’ exploiting the situation could do some good, in much the same way that short traders serve an important function by putting pressure on weak companies to strengthen themselves or be acquired. “To some extent, the opaqueness might be mitigated,” Mr. Sundaresan said.

Market sources said it would be impossible for traders to “blow up” a city or a state with credit-default swaps because governments do not issue stock. When traders have helped drive companies to destruction in the last few weeks, they have generally used complex strategies that combined stock positions with credit-default swaps.

In July, Lehman Brothers alerted clients that Illinois was “a potential buy opportunity” for short traders, because credit-default swaps on its debt were relatively cheap.

Illinois has a budget deficit and a sickly public pension fund, Lehman Brothers observed. But Standard & Poor’s had rated it double A — just like Texas, which has a budget surplus and copious oil and gas money. The discrepancy suggested that Illinois had been overrated and was ripe for speculation.

“They’re looking at Illinois and saying, ‘the spreads are low because they’ve got bogus accounting,’ ” said Mark Ruloff, an actuary and director of asset allocation for Watson Wyatt Investment Consulting. “The market sees through some of the opaqueness.”

As the market turned, though, a trader actually would have made a bigger profit with a credit-default swap on Texas. Amid the financial chaos of mid-September, when the value of swaps spiked, Texas was hit by Hurricane Ike. Hurricane insurance for property on its Gulf Coast was available only through a state-run pool. So the price of protection against a Texas default rose even more.

Lehman Brothers also suggested trades on places including Florida, which was on the hook for hurricane damage; Nevada, which was dependent on the gambling business; and New York City, because its fiscal health was closely linked to Wall Street.

Lehman, which declared bankruptcy last month, was one of the largest market makers in municipal credit-default swaps, along with Citigroup , Goldman Sachs and Merrill Lynch. The loss of trading capacity and expertise could crimp the municipal swaps market. But other factors are driving the market’s growth.

Municipal credit-default swaps, created in 2004, mostly gathered dust until 2007. After the insurance companies that specialized in municipal bonds became troubled, credit-default swaps emerged as an alternative form of insurance. Even though municipalities rarely default on their bonds, the insurance was popular because it made municipal bonds seem utterly foolproof. That sense of heightened security made the bonds easier to sell, lowering communities’ borrowing costs.

In May, a municipal credit-default swap index, the MCDX, was introduced by Markit, a financial data company. The index allows traders to take positions on whether government creditworthiness overall is heading up or down. Its debut coincided with the bankruptcy filing of Vallejo, Calif. The city of 117,000 ran out of money after promising its police officers and firefighters much richer benefits than it could afford.

That filing created more interest in municipal credit-default swaps. It also cast a bright light on the possibility that some governments had promised benefits they could not pay, even though their financial statements and credit ratings seemed fine.

Mr. Love, of the New Jersey investment board, has recalculated the value of the pensions promised to the state’s public workers, using the method that a bank would use to measure its book of business. He found a $56 billion deficit, more than three times the $18 billion that the state was disclosing in its bond offering statements. The state Legislature uses the lower number when approving new benefits and balancing the budget.

“The thing you’re sensing is that the capital markets are in one world, and the actuaries and bond counsels and the legislators are in another world,” Mr. Love said. “And that sounds like an arbitrage opportunity.”

Copyright © 2012 The New York Times

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