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The Muni CDS Sitdown

Various members of the NetNet crew are in and out this vacation and snow-filled week, so we've asked a few friends to fill in. The following is from New York City-based investment advisor Joshua Brown ...

Music: Cue strains of a mournful mandolin.

Exterior: An out-of-the-way red sauce Italian joint in the Arthur Avenue section of the Bronx.

Cut to Interior: The heads of the Five Families hunched over a checkered tablecloth (with attorneys behind them) agreeing to split the municipal bond credit default swaps pie five ways in 2011. "There's more than enough profit here for all of us, boys."

***

This actually happened, you guys (but probably in a not so Mafia-ish way). My flair for the dramatic notwithstanding, the heads of the biggest Wall Street investment banks did in fact get together for a conversation about standardizing muni CDS contracts. This is happening as a prelude to a coming firestorm of activity for 2011 in the muni bond space.

From theWall Street Journal:

Separately, five large derivatives dealers—Bank of America Corp.'s Bank of America Merrill Lynch, Citigroup Inc., Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and Morgan Stanley—met last month in New York to discuss standardizing the paperwork for "muni CDSs" in an effort to attract more buyers and sellers.

The entire muni bond market is under increasing strain heading into the new year. Investors have pulled $9 billion from muni bond funds since Thanksgiving. In the meantime, analyst Meredith Whitney is leading a chorus of bears who are looking for a raft of defaults across the country.

Credit default swaps allow for the hedging of exposure to defaults on bonds. They are used by holders of these bonds as a sort of insurance. They are more notoriously used by hedge funds and high-flying bank traders as a means of speculation. The entire muni bond market is about $2.8 trillion in size — yet there are only $50 billion in outstanding CDS contracts written against it. As holders get nervous and hedge funds come in to the trade betting on drama in the space, more CDS will be written by all the major banks.

The merchant mentality of the banks is always and above all else to give the "cutomers" what they want. And what they want is a more liquid and transparent way to get exposure to the coming pain for states like Illinois and California. This agreement to standardize products is coming just ahead of a massive surge of interest in the products.

***

Interior: "It's agreed then," said one of the Dons as he raised his glass. "In 2011, we feast together! Salute!"

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