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High finance bookies betting both sides of municipal bonds

April 30, 2010

Now those who crucified taxpayers on a housing cross are casting lots upon the vesture of states' self-inflicted wounds.

Yes, beleaguered taxpayers, the financial gambling that enriched a few by possibly causing - certainly amplifying - world economic collapse is growing like cancer in public debt markets.

Investors are trading derivatives that bet states, municipalities and public authorities will default on bond issues, historically the closest to sure things on which to wager. Sure, the returns are low, but risk is zero because bondholders ultimately have power through government to imprison citizens who refuse to pay. Not even banks get to do that.

But is the risk zero?

Odds for these side bets on bond bets are getting worse as investors wake up to the hard fact that governments are in deep trouble, have been cloaking it for a decade and bondholders are in line behind pension funds and who knows what else for money squeezed out of taxpayers.

And there is growing dim remembrance that technically taxpayers have power to change the game and say no.

Of course those booking the bond bets and the side bets against the bonds created yet another casino for bets derived from those, like the collateralized debt swaps that turned a limited subprime home mortgage problem measured in billions of dollars into a worldwide catastrophe measured in trillions.

At least one state treasurer is miffed about it. California's Bill Lockyer recently asked investment banks making hundreds of millions selling state bonds why at the same time they touted $27.5 billion in bets those bonds would default.

According to a press release, Lockyer "voiced concern about banks selling the State's bonds on one hand, and on the other hand betting against, or facilitating bets against, those bonds." Good question.

 

Another is what impact that has on borrowing costs eventually picked up, as are all, by taxpayers. Yet another is the big question: What if, as in housing, the unthinkable happens and bookies can't cover side bets?

The odds, while long, are getting worse. According to Markit Financial Information Services, as quoted in the Wall Street Journal, high finance bookies are giving 54 to 1 that California won't pay off on the very bond issue bets the bookies are pushing. Average odds are 77 to 1.

That means it costs state taxpayers 1.85 percent more to borrow money, or $18,500 a year for every $1 million in bonds on top of whatever interest they have to pay to attract increasingly skittish investors.

And that doesn't even include the ultimate potential risk and cost of unregulated trading in the derivatives based on the side bets.

It sure can add up. As we learned the hard way with mortgages, it can compound.

The bookies make money on both sides of the bets, make more trading the bets, and then can just walk away from the table when the game caves in, leaving guess who to eat the losses? Taxpayers.

What financiers really are betting on is the tattered garment of visible debt state and local governments increasingly must use to cover the horrible hidden wounds that leave them on the edge of bankruptcy despite taking $25 billion more from citizens in 2009 than in 2006.

On top of visible debt, states and municipalities owe trillions in false retirement promises, deferred capital projects, unfunded program commitments, unpaid "self-insurance" premiums, Medicaid obligations, IOUs and a myriad accounting tricks used to hide true deficits.

Now the day of reckoning is here, and nobody knows exactly where bondholders stand.

Financial Times reports discussion of default -- as in Harrisburg, Pa., and Detroit -- could disrupt the $2.8 trillion municipal bond market.   

According to Income Securities Investor, more than 200 municipal, corporate and international bond issues totaling $20 to $50 billion default in a "typical" year. "In addition, there are 300-400 defaults and bankruptcies still unsettled."

What happens if we have a few years that are not typical? Just crucify taxpayers again.

 

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