We began the week reporting how bond yields on Illinois State general obligation debt had overtaken similar bond yields on California State debt so it probably isn’t a surprise to end the week reporting how Illinois credit default swap prices have now also overtaken California credit default swap prices. Illinois is now the highest priced (high price implying riskiest or most likely to default) municipal entity in America. It is also amongst the riskiest municipal and sovereign debt names in the world, slightly above Portugal CDS at 305 bps but below Dubai CDS and Iraq CDS at 465 bps and 400 bps, respectively.
Illinois CDS ended last week at 283 bps, slightly below the 290 bps level of California CDS. In a week’s time, Illinois CDS have risen to a new record high of 309.1 bps yesterday overtaking the 299.6 bps level of California CDS.
The price rise comes as Illinois just finished selling $300 million new Build America Bonds municipal bonds yesterday at record high spreads of 297 bps over benchmark 30-year US Treasury bonds. Businessweek reported that Illinois sold similar debt in April at 205 bps and 210 bps over the same benchmark.
Illinois State Finances
As previously reported, the rise in Illinois swap prices reflects increasing risk aversion to the state’s finances which include a $13 billion budget deficit and unfunded state pension plan. While things may appear bad, investors and analysts don’t necessarily think that the worst is over.
A recent report by Medill Reports, run by Northwestern University’s Medill School of Journalism in Chicago, highlighted the distressed nature of the Illinois Teachers Retirement System (ITRS). Medill answered the question of just how bad it was saying “after losing $4.4 billion on investments in fiscal year 2009, and 5 percent on investments in fiscal 2008, the teachers’ pension is now underfunded by $44.5 billion, or 60.9 percent, according to the Commission on Government Forecasting and Accountability’s March 2010 report. By comparison, only 20.3 percent of the Chicago Teachers’ Pension Fund is unfunded.”
Analysts worry that in order to make up the previous losses and close funding gaps, pension funds like the ITRS may be engaging in riskier investment behaviour (similar to that of failed municipal bond insurers like Ambac, FGIC and MBIA) which could backfire and leave the state with even bigger losses in the future instead.
Case in point is demonstrated with ITRS’ derivative portfolio which includes controversial investments including long positions (i.e. selling protection) in sovereign and municipal credit default swaps. Specifically, on the sovereign side, ITRS’ portfolio includes Abu Dhabi CDS, Brazil CDS, China CDS, Japan CDS, Mexico CDS, Panama CDS and South Korean CDS. On the municipal side, their portfolio includes New York State CDS, Michigan CDS and the highly talked about California CDS. This is in addition to their other derivative positions including interest rate swaps, inflation swaps, options and swaptions, and other corporate CDS positions CDS indices.
Being a CDS-focused site, we mainly focus on their credit derivatives, some of which also include positions in Berkshire Hathaway CDS, GMAC CDS (i.e Ally Bank), MetLife CDS and even Rosselkhozbank CDS (Russian Agricultural Bank CDS). Examples of non-CDS positions, though, include interest rate swaps “linked to the Brazilian Interbank Deposit Rate and Euribor in a bet that inflation would stay low in Europe but rise in emerging markets” according to Medill.
Municipals not as bad as Sovereigns?
Despite the heightened levels of Illinois and other American municipal credit default swaps, other analysts point out that the extent of state municipal finances is probably not as bad as some of the other Euro-zone sovereign state finances that they are compared to. The Economist recently reported,
“Comparisons between incontinent American states and Greece are all the rage. Though this is an exaggeration, credit-default-swap spreads, which measure investors’ expectations of default, are wider for some American states than they are for some of the euro zone’s other peripheral economies [see chart reproduced here].
There are other similarities. Like members of the euro zone, American states may not declare bankruptcy, cannot be sued by creditors and, thanks to America’s federal structure, cannot be forced to behave by a higher level of government. They also do not issue their own currency, so inflating away their debt is not an option. And, like many European governments, state legislatures and governors are reluctant to impose the necessary pain. The Illinois legislature recently passed a budget for the next fiscal year, starting on July 1st, which leaves a $13 billion deficit to be closed.
The parallels with Europe are unfair, though only up to a point. American state and local debt last year was $2.4 trillion, about 16% of gdp. But most of that debt is issued by local governments or state agencies and has specific assets or fees, such as road tolls, earmarked for paying it back. Even in the weakest states, debt that needs to be paid out of general tax revenue was under 5% of GDP last year. Greece’s was 115%. The numbers for deficits show an even greater contrast. California’s deficit, assuming the state fails to close it, would equal only 1% of its GDP, compared with 14% for Greece and 9% for Portugal last year.
Greece and Portugal do not have separate federal and state governments, however. So a fairer comparison would take account of gross American federal debt, which currently stands at 85% of GDP. This underlines the fact that most of America’s debt problem is federal not local. The consequence is that, because states’ refinancing requirements are relatively low compared with their tax revenues, no state faces an imminent liquidity crisis. California’s treasurer, Bill Lockyer, is fond of saying that California will not default unless there is thermonuclear war.”