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.

George Washington Bridge
Oliver Quillia
George Washington Bridge

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.

For Investors

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.”

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.”