(For the record, most of the information that I have pieced together in this post derives from a series of complaints filed by the Securities and Exchange Commission against deal participants, see here and here – which I feel fairly confident in citing, since substantially all of the information is based on email correspondence, taped phone conversations, and the testimony of bank employees – and from this timeline of events prepared by the Bond Buyer.)

Back in 1996, Jefferson County entered into a consent decree with the federal Environmental Protection Agency to make extensive improvements to its sewer system.  The county financed the improvements through several bond offerings.  The project was originally estimated to cost around $1.5 billion, but its scope eventually climbed to $3 billion.  (Sewer rates quadrupled over four years in order to pay for the project.)

In 2002, the FBI launched an investigation into the county’s construction program, which resulted in the conviction of 21 people, including contractors, county commissioners, and county employees.  The convictions were mainly related to construction firms bribing local officials to obtain business.  

The practice of bribery did not disappear with those convictions, unfortunately.  According to the SEC, in March 2002, Charles LeCroy, then managing director for JP Morgan Securities’ southeast regional office in Orlando, Florida, sent a series of emails to his superiors discussing how one of the firm’s competitors (three guesses who) had successfully scored new municipal underwriting and swap business by enlisting the paid support of the politically connected principals and employees of local broker-dealers.  LeCroy’s superiors endorsed this strategy, and he provided them with estimates (in emails, no less) of what the going rate for paying these folks off would be. 

In their first experiment with Jefferson County, LeCroy and Douglas MacFaddin, managing director of JP Morgan’s municipal derivatives unit, focused their efforts on two commissioners, and mostly on Commissioner Jeff Germany.  These commissioners had not been reelected and wanted to execute a $1.8 billion debt refinancing before they left office in November in order to direct payments to people who had supported their campaigns – specifically through Gardnyr Michael and ABI Capital, two local broker-dealers.

(As an aside, I am often amused by the progressive bias toward using smaller firms rather than megabanks.  It was the good old boys at the smaller firms that JP Morgan and other banks used to gain access to local officials in this and other frauds, and the people at those smaller firms had already been deeply entrenched in corrupt schemes with public officials for decades.  In fact, as you will see, these smaller firms played the megabanks off of each other, which only increased the cost of the schemes to taxpayers.)

The county ended up issuing the bonds in three series: 2002-B, 2002-C, and 2002-D.  The 2002-C series was the largest component of the transaction, and was the only series that involved auction rate securities and (theoretically offsetting) interest rate swaps.  Although the county had selected Gardnyr Michael and ABI Capital to serve as co-underwriters on the 2002-B and 2002-D series, they were not eligible to work on 2002-C because Alabama state law imposes net capital requirements on counterparties to swap contracts, which the two firms did not meet.

The state’s capital requirements for swap counterparties are significant because JP Morgan’s strategy for producing the funds to pay off these firms (in exchange for the firms persuading county commissioners to hire JP Morgan) was to incorporate the cost of the payments into the interest rates on the county’s swap agreements.  JP Morgan essentially structured the transaction so that county taxpayers would be the ones paying to bribe their own officials.  To pass the funds on to Gardnyr Michael and ABI Capital, JP Morgan had to devise some role for the firms in a transaction that it would have been illegal for them to participate in.

Humorously, the firms had sent invoices to JP Morgan for their work as “co-managers on the Jefferson County, Alabama swap,” language that would have made anyone who had ever worked with swaps believe something was amiss (or question whether the local bankers even knew what an interest rate swap was).  After much debate captured in taped phone conversations (“we probably should not say the firms advised us on the swap or structuring…”), they settled on writing something to the effect of “Jeff Germany told us to pay them” on the invoices.  (When in doubt, say it wasn’t you.)  JP Morgan ended up wiring $250,000 each to the local firms, who provided no actual services to the county, equivalent to one-third of JP Morgan’s $1.5 million underwriting fee on the deal.  (Because the cost was being passed on to the county, the JP Morgan bankers were mostly indifferent to how much the firms were being paid.) Those firms turned around and wired a large portion of the fees to some of Germany’s campaign contributors.

Securing a second transaction through the same means proved to be a little more complicated for JP Morgan’s bankers because Goldman Sachs had already beat them to establishing a relationship with the new crop of county commissioners.  In November 2002, a fellow named Larry Langford took over as president of the Jefferson County Commission.  Langford was explicit in his intention to direct as much of the county’s business to Blount Parrish, a local broker-dealer owned by Langford’s long-time friend and supporter, William Blount, which had not received any of the county’s business since 1997.  (Incidentally, in 1998, when Langford was mayor of the city of Fairfield, Blount Parrish served as underwriter on bonds used to finance a new theme park.  The park was mismanaged, did not generate as much revenue as projected, defaulted on its debt, and was placed into receivership by bondholders.  One has to love the masses for consistently electing such people to public office, when disaster follows them wherever they go.)

Both JP Morgan and Goldman Sachs had been pitching new bond offerings and swap arrangements to the county.  Blount Parrish had wanted to participate in any new offering, but like Gardnyr Michael and ABI Capital, did not meet the state’s net capital requirements for that kind of transaction.  Blount suggested that Langford hire Goldman Sachs to underwrite a new 2003-B deal because Blount already had a “consulting” agreement with Goldman.  Another broker-dealer, Rice Financial Products, had likewise been pitching offerings to the county through a local “consultant” that was also good friends with Blount. 

To ensure that JP Morgan won the county’s business, LeCroy and MacFaddin cut a deal with Langford to pay the whole bunch off.  (As I said before, since the JP Morgan bankers were confident no one would check their swap math, there really was not much of a ceiling on the cost they would pass on to taxpayers.)  Pursuant to their negotiations, LeCroy and MacFaddin paid Goldman Sachs $3 million and Rice Financial $1.4 million.  Goldman Sachs turned around and paid Blount Parrish $300,000.  Goldman Sachs and Rice Financial, having far more CYA expertise than the local bankers JP Morgan had previously worked with, did not try to insert themselves into the county’s transactions.  Instead, JP Morgan entered into a swap with the county (at an inflated cost to the county), and Goldman and Rice entered into separate corresponding swaps with JP Morgan.  That was how the money was passed from one firm to another.  Just to be clear, the net effect of this transaction was that Jefferson County taxpayers ended up paying Goldman and Rice not to do business with the county.

(Humorously, Goldman sent a CYA letter to Langford, explaining that the firm was passing on “consulting” fees to Blount Parrish, and recommending that Langford disclose the payment to the county’s bond counsel on the transaction, so that the bond counsel could decide whether or not the payments should be included in the bonds’ offering documents.  I’m sure Langford’s reaction in reading the letter was something like, “Goodness. How could we have forgotten to tell our bond counsel that this transaction was a massive fraud? We should rectify that immediately.”)

As you have likely surmised, Langford was not funneling money to Blount out of the goodness of his heart.  Around the time Langford took office, he was stressing out about the $70,000 in credit card debt he had amassed buying rockstar duds.  He confessed as much to his friends Blount and Albert LaPierre, a lobbyist.  LaPierre told Langford to apply for a loan at Colonial Bank in Birmingham, which he did.  Why Colonial Bank?  Blount’s girlfriend at the time was the chief credit officer for the bank.  She approved Langford for an unsecured, six-month, $50,000 loan, despite his less-than-desirable credit. 

When the loan was due in January 2003, Langford asked LaPierre to pay off the loan.  Blount had his girlfriend approve a $50,000 loan for LaPierre, which was used to pay off Langford’s debt.  Blount eventually repaid the loan on Langford’s behalf.  Blount tried to get Colonial Bank to offer Langford another $75,000 loan, as Langford continued to live large on his credit cards, but Colonial turned him down.  Blount then provided the money for Langford himself, using LaPierre’s lobbying firm as a conduit.  On a separate occasion, Blount funneled money through LaPierre’s lobbying firm to Langford so that Langford could pay close to $30,000 in taxes to the IRS.  Blount’s payments on Langford’s behalf were sandwiched in between two large bond offerings, for which Blount’s firm served as co-underwriter.

By the time the second major bond offering was being contemplated, JP Morgan’s bankers were getting a little exasperated by Blount’s demands.  Much to their relief, Goldman had taken itself out of the picture (“we’ve got a lot more latitude dealing with [Blount] than with Goldman Sachs”), but Blount, who understood that he had Langford wrapped around his little finger, was demanding 15% of JP Morgan’s fees on the next swap agreement.  JP Morgan ended up paying Blount Parrish $2.6 million on the transaction.  JP Morgan also paid $150,000 each to their old friends Gardnyr Michael and ABI Capital, who had hired a friend of Commissioner Sheila Smoot as a “consultant” so that they could stay in the game.  (They also paid $1,122 to send another commissioner to New York for a spa trip, among other gifts – very generous people.  A judge would eventually sentence her to 3 years’ probation, 200 hours community service, and to pay a $20,000 fine.)  Again, all of these payments were built into the county’s cost on the swaps. 

This arrangement continued for several other transactions.  In the end, the fraudulent payments LeCroy and MacFaddin made to secure the county’s business from 2002 to 2003 totaled $8.2 million.  (I think somewhere along the line JP Morgan also made payments to LaPierre, who wasn’t even in the securities business.)  Before the refinancing transactions with JP Morgan, over 95% of the county’s debt was in traditional, fixed rate bonds.  After the refinancings, 93% was variable rate debt, including $2.1 billion of auction rate securities.  The debt was synthetically fixed through $5.6 billion notional of swaps.

Although the Bond Buyer reported in 2004 that the SEC was looking into the county’s bond offerings, the SEC did not begin a formal investigation until 2006 and did not begin issuing subpoenas until 2007.  In the meantime, the county restructured three swap agreements with a notional amount of $1.56 billion with Bear Stearns and one swap agreement with a notional amount of $380 million with Bank of America.  Blount Parrish received payments under the deals with Bear Stearns.  (That’s how insane these people were – they still kept going, even though the SEC was looking into their dealings.  I distinctly remember wondering during those years why the SEC was taking so long in nailing these folks.  Jefferson County’s story had been a regular feature in industry papers for years.)

The county’s downward spiral began in earnest in 2008 when the auction rate securities market collapsed.  As mostly everyone knows, the investment banks serving as auction agents on the bonds had been propping up auctions for months as investors were becoming increasingly skeptical of the liquidity of their holdings, but the banks eventually had to withdraw their support.  In January, the credit rating agencies went on a rampage downgrading bond insurers, including FGIC and XL Capital Assurance, which insured Jefferson County’s debt.  Jefferson County’s auctions failed, leaving the county paying the penalty interest rates stipulated in bond documents, as much as 10%.  (This was happening to all issuers in the ARS market by February.  Whether the penalty rate was even remotely affordable depended on how bond documents were drafted and whether the penalty rate was a fixed rate or based on an index plus a spread.)  Jefferson County’s VRDO remarketings also failed, which forced the banks providing Jefferson County’s credit facilities to buy back the bonds from investors.  As the Fed started lowering interest rates, the payments the county received on its swap agreements decreased, adding to the county’s expenses.  S&P cut the sewer bonds’ ratings to junk in February and was followed by Moody’s in March. 

JP Morgan and the county’s other creditors entered into a series of forbearance agreements with the county (which allowed payments to be deferred). The county commission, now under the leadership of Bettye Fine Collins (Langford had moved on to become mayor of Birmingham), refused to post collateral on the swaps.  The next month, S&P cut the county to D, and the SEC filed securities fraud charges against Langford, Blount, and LaPierre.  A federal grand jury began investigating the deals.

Beginning in the spring of 2008, the county began hiring and firing various firms (like Merrill and Citi), who were to advise the commission on its debt restructuring options.  (Those firms were soon to have larger problems of their own…)  It was at this time that the county began tossing around the idea of filing for Chapter 9 bankruptcy.  The state’s pension system had considered purchasing the county’s debt – genius, I know – but only on the condition that the county prepared a bankruptcy filing to force creditors into serious negotiations.  The commissioners discussed filing for bankruptcy at pretty much every meeting for the next three years, and they are still discussing it.

In September 2008, the trustee on the bonds declared that the bonds were in default.  The bond insurers and trustee filed a lawsuit against the county in federal court requesting that the court appoint a receiver for the sewer system.  In November, the judge honored their requests and appointed John Young, president of American Water Services, and John Ames, a lawyer at Greenebaum, Doll & McDonald, as special masters of the sewer system.  (Placing an entity in receivership can only happen outside of Chapter 9.)  The special masters ultimately recommended that the sewer system increase user rates.

That same month, JP Morgan made the bombshell announcement that the firm would exit the municipal swap business altogether and fire a bunch of employees at regional offices.  The firm was getting hit with negative publicity from all sides, due not only to the situation unfolding in Jefferson County, but also the Justice Department’s antitrust probe into municipal derivatives.  (Bloomberg reported at the time that the county’s financial adviser had estimated that JP Morgan had overcharged Jefferson County by as much as $100 million for the various sewer refinancings.)  The bank said it would continue to provide swaps for some exempt borrowers, such as hospitals.

Things became much worse for Jefferson County in 2009.  A local court struck down the county’s occupational and business license taxes (ruling that the state legislature had enacted the taxes illegally during the legislative session), a decision that was eventually appealed to and upheld by the Alabama Supreme Court.  Those taxes comprised one-third of the county’s general fund budget.  The county went into full austerity mode after the ruling, shutting down offices, furloughing employees, and so on.

Shortly thereafter, JP Morgan / Bear Stearns decided to terminate the bank’s interest rate swap agreements with the county, which it would have had the contractual right to do, given the county’s financial position and unwillingness / inability to post collateral.  (I am not suggesting that the contracts were legitimate, just saying those are standard terms of swap agreements.)  The bank notified the county that it owed JP Morgan approximately $648 million in swap termination payments.

In anticipation of being charged with securities fraud, JP Morgan agreed to settle with the SEC, making a $50 million payment to Jefferson County for the purpose of assisting displaced county employees, residents, and sewer ratepayers; paying a $25 million penalty to the SEC; and agreeing to forfeit the $648 million of swap termination payments.  Considering how destructive the transactions proved for the county, the settlement seemed beyond absurd.  Securities fraud suits against LeCroy and MacFaddin are still pending.  (Incidentally, in 2005, LeCroy was sentenced to three months in jail for wire fraud after an investigation into whether Philadelphia bond business was directed to supporters of Mayor John Street.)

Langford, Blount, and LaPierre ended up being indicted for conspiracy, bribery, and fraud.  Blount and LaPierre pled guilty to the charges and were sentenced to 52 and 48 months in prison, respectively.  Langford was tried, found guilty, and sentenced to 15 years in prison.

Last month, the county announced that it had reached a settlement agreement with its creditors (JP Morgan is the county’s largest bondholder by far), wherein bondholders would write off $1.09 billion of debt, and the county would restructure the remaining $2.05 billion and enact a series of rate increases (three annual increases of 8.2%, beginning in November, and 3.25% annual rate hikes after 2014).

Unlike Harrisburg, where the state of Pennsylvania moved swiftly to intervene in the city’s financial situation, the state of Alabama has resisted providing any assistance to Jefferson County over the years.  Multiple legislative sessions have passed where the Alabama legislature has failed to take action on legislation introduced to help the county restructure its debt or replace the occupational tax revenues it has lost.  Part of the problem is that there is a tradition within the Alabama legislature where lawmakers will defer to the local delegation to make decisions on local matters, and the delegation has to be unanimous in its position.  (The fact that the legislature has proven to be so dysfunctional in addressing Jefferson County has had a detrimental effect on all municipalities in the state, which have been paying a premium to borrow in the bond market.  A number of market analysts have cautioned investors against investing in Alabama debt.)

Given the legislature’s track record, it is difficult to be optimistic about the fate of the county’s settlement with creditors.  In order to reduce the county’s interest cost in the debt restructuring, the settlement assumes the debt will be issued with a moral obligation pledge from the state.  The legislature would need to approve that provision plus the establishment of a new public corporation to manage the sewer system.  So far, it looks like the Alabama delegation is split over supporting the settlement.  Some local lawmakers are opposed to the rate increases, which they regard as unjust.  (Perhaps they mistakenly believe that filing for bankruptcy would not involve additional costs for local residents?)  The county could be forced to file for bankruptcy anyway if legislators draw out their deliberations, because there is not enough liquidity in the county’s general fund to carry the government for much longer.  As things stand now, Jefferson County filing for bankruptcy can be avoided.  If the county does have to file, it will be entirely due to Alabama policymakers.

On a somewhat-related tangent, Mark Schwartz, attorney for the Harrisburg City Council and resident conspiracy theorist, has pointed to Jefferson County’s bankruptcy threats in defending the council’s decision to file, suggesting that only after Jefferson County threatened to file was the county able to make progress in negotiating with creditors.  This is simply untrue.  As I pointed out earlier, Jefferson County has been threatening to file for bankruptcy for literally three years now.  Jefferson County’s creditors have likely waited until now to settle with Jefferson County because many other things that could have potentially impacted the county’s finances have had to play out (such as the occupational tax case winding its way through the state courts and pending legislation on debt restructuring / new tax revenue).  It should also be noted that Jefferson County has some leverage over its largest creditor that Harrisburg does not have, namely that its largest creditor had been charged with securities fraud in the subject debt transactions.  Harrisburg’s financial woes, on the other hand, derive entirely from local officials’ stupidity.  In the end, the only thing Jefferson County and Harrisburg have in common is their insolvency, which is not particularly instructive when comparing their options. 

I hope that all the additional detail on these cases has helped readers understand the limitations of making generalizations about distressed credits and the problem with drawing macro conclusions from isolated events.

Whitney’s call for “50 to 100 sizeable defaults” totaling “hundreds of billions of dollars” has not even come close to materializing.  According to Richard Lehmann’s Distressed Debt Securities Newsletter, there have been $1.18 billion of municipal defaults through September 22, 2011, compared with $3.61 billion for 2010.  In an earlier post, Default and Bankruptcy in the Municipal Bond Market, I suggested that conduit debt for healthcare and housing would continue to be the largest source of municipal defaults this year.  In fact, healthcare credits have accounted for 39% of this year’s monetary defaults. The single largest monetary default was a housing project.  The Clare at Water Tower in Chicago, a retirement facility that was financed in 2005 with $229 million of bonds, failed to make an installment payment to cure a shortage in its debt service reserve fund, which was a default event that triggered a mandatory tender on $125 million of floating-rate bonds.  This meant the trustee had to make a draw on the credit facility that supported the debt.  Lehmann has noted that defaults on Florida dirt bonds (which are secured by special assessments on real property) have been the “single biggest [on-going] default event in the history of the municipal market,” with 77% of bonds issued since 2003 having defaulted.  (That figure includes bonds that have tapped debt service reserve funds.) 

Even more to the point, all but one of these defaults have been on revenue bonds.  The only monetary default on the general obligation debt of a municipality this year involved the city of Brighton, Alabama (population 2,945).  According to Bloomberg, the city (which is located just outside of Birmingham) lost 19% of its residents from 2000 to 2010. It missed a $22,783 interest and $35,000 principal payment on its $1.2 million of GO warrants.  While I am sure this event is tragic for someone, it hardly represents the Armageddon that Whitney predicted.

For much of the first half of the article, Lewis seems to be trying to support Whitney’s argument that states do “a poor job of providing information about their finances to the public,” and that “the scary thing about state treasurers … is that they don’t know the financial situation of their own municipalities.”

Lewis decides to test her assertion, at least as it pertains to California, which is the state Whitney says is in the worst position.  Of course, Lewis does not interview Bill Lockyer, who is the state’s treasurer, but Arnold Schwarzenegger, the former governor.  His rambling interview with Schwarzenegger, which takes place while the two ride bicycles along the beach, mostly covers the governor’s improbable ascent to political leadership and struggles while in office.  Lewis leaves his audience with the impression that the state’s political leadership lacked a nuanced appreciation of the state’s financial management, and that the administration was pretty much winging it.  Schwarzenegger likewise confessed to being clueless about local governments in the state: “I’m not into the local stuff … I was born for the world.” Um, okay…

I have the feeling that if Lewis had interviewed Lockyer instead of Schwarzenegger, he would have come away with a very different understanding of state and local finance and a very different view of public officials.  But Lewis would not have had to interview anyone to see that Whitney was wrong about the level of financial information that the state government provides its residents and potential investors – he could have just visited Lockyer’s website.  On the website, Lewis would have found: a summary of the enacted budget; agency-level detail of the enacted budget; the Legislative Analyst’s Office’s analysis of the enacted budget; the latest monthly General Fund cash receipts and disbursements; a discussion of trends in cash receipts and disbursements; the state’s annual debt affordability report; the latest report on outstanding and authorized state bonds; a searchable database for state and local debt; California state and local government debt issuance data; the California Debt and Investment Advisory Commission’s monthly newsletter; or any of a myriad other publications related to the financial condition of the state and its political subdivisions.  Of course, Lewis could also review the state’s financial statements for the last decade at the controller’s website.  While state policymakers have spent considerable time debating spending issues, I think it would be difficult to argue that financial trouble catches officials off guard.  And while disclosure can and should always be improved, is this not a commendable effort at transparency?  How would Lewis’ audience view state officials’ awareness of state and local financial affairs differently if he had mentioned that this information is publicly available and not a mystery as Whitney suggests?  (Note: I do not own or work with California bonds.)

What about the monthly seminars the state hosts to educate local government officials on bond math, derivatives, and similar topics? Lewis could have also attended one of the financial management-related conferences the state hosts for issuers, market participants, and the media each year.  (They are excellent and informative events.) 

As I was reading Lewis’ defense of Whitney’s arguments, it struck me that he probably did not read Whitney’s Tragedy of the Commons report (as I have).  If he had, it probably would have occurred to him that she mostly used data and analysis provided by organizations like the National Association of State Budget Officers (which publishes reports explaining the logistics of states’ individual budget processes and comparing state budget actions) and the Pew Center on the States (to name only a couple).  She doesn’t really do any of her own analysis at all – her work reads like an incredibly verbose high school student’s book report.  The only remarkable thing about Whitney’s research is that she somehow convinced her clients to pay $100,000 for information that was easily a Google search away (plus a considerable amount of political bloviating).  He also would have known that her opinions about local governments were not based on any specific analysis of local credits.  She said there would be hundreds of billions of dollars’ worth of defaults in a sector of the municipal market that she had not even studied.  And Lewis seriously wishes to defend this kind of reckless and irresponsible behavior?

Lewis makes two other undeveloped arguments in support of Whitney.  The first is that her claims have been misrepresented.  It seems fairly silly to say that her words have been misrepresented when they have been captured on video and repeated ad nauseam over the past twelve months.  And much has been made of how Whitney conflates what she calls “defaults on social contracts” and what most rational people would consider a default, which is a failure to observe terms of the bond contract or a failure to make timely principal and interest payments.  (That is not misrepresenting her views, but providing a legitimate criticism of her sense of what constitutes a credit event.)  In interviews, Whitney has generally moved back and forth between the two as is convenient. 

But “she was referring to the complacency of the rating agencies and investment advisers who say there is nothing to worry about,” Lewis offers.  As I have already explained, until recently, the rating agencies inexplicably rated munis on a tougher scale than other kinds of credits, and most of the monetary defaults the market sees are on bonds that had junk ratings or were unrated when issued.  Lewis would know this if he had actually researched credit events in the marketplace before writing his article.

Lewis’ other defense is that:

Whatever else she had done, Meredith Whitney had found the pressure point in American finance: the fear that American cities would not pay back the money they had borrowed.  The market for municipal bonds, unlike the market for US government bonds, spooked easily.  American cities and states were susceptible to the same cycle of doom that had forced Greece to seek help from the International Monetary Fund.  All it took to create doubt and raise borrowing costs for states and cities was for a woman with no standing in the municipal-bond market to utter a few sentences on television.

Ah, yes, the inevitable analogy to Greece.  I have explained in prior posts why this analogy makes no sense, and how state and local governments are not dependent on short-term market access in the same way the US government and European sovereigns are.  When municipal rates increased, state and local governments simply stopped issuing bonds.  The fact that they could do so and not have immediate, bailout-inducing debt crises communicates volumes about the financial strength of the credits in this market.  Also, the highest the benchmark Bond Buyer 20-Bond GO index reached following Whitney’s 60 Minutes interview was 5.41% on January 20.  What conclusions would Lewis’ audience have drawn from his article if he had compared that to yields on Greek bonds?  I would also submit to you that the market will be less vulnerable to such hysteria going forward precisely because Whitney has been so embarrassingly incorrect.  Trusting Whitney was an expensive lesson for dumb money.  (It was a terrific opportunity for private wealth and more savvy investors, however.)

The truth is that Whitney’s 60 Minutes interview coincided with the expiration of the Build America Bond program, which had caused a glut of new issuance in the market and was already driving rates up.  Major structural shifts were already underway in the market, and the BAB program had been the last support.  Either accidentally or deliberately, Whitney made her call in the middle of a perfect storm for munis.  And she was still wrong.

I do not have much to say about the remainder of Lewis’ piece except to express a general frustration with the way journalists seem to equate anecdotal evidence with genuine financial analysis in terms of credibility.  Yes, Vallejo’s situation is a prime example of how political paralysis can morph into a vicious economic feedback loop and legal industry stimulus program.  But presenting Vallejo as indicative of a trend is another matter.  Did other governments make generous commitments during periods of economic prosperity?  Sure, it is almost impossible for political officials not to do this kind of thing.  But are other governments pushing themselves to the brink by not addressing this issue?  Lewis’ audience wouldn’t know, because he did not interview the mayors of any of the two-thirds of the 296 California municipalities (as surveyed by the League of California Cities) that are in the process of renegotiating changes to their retiree benefits plans.  I suspect if Lewis had, he would have discovered that other cities have internalized Vallejo’s situation.  

I hope no one will read this and think that I believe the municipal bond market is without risks.  This is not true.  (The most likely source of a major disruption in the municipal bond market in the near future is the tax status of the bonds – not massive defaults – in my opinion.  But that is a topic for another post.)  The municipal bond market is a complicated market.  Many investors I have spoken with fail to appreciate the differences between claims, that there are different sectors in the market, the difference between conduit and government bonds, etc.  This is a market where the difference between issuers matters.  People like Lewis and Whitney, who are trying to sell a canary-in-the-coal-mine version of the market, are doing investors a disservice. There are hundreds of municipal bond market professionals that understand these matters on a granular level, have more than a couple years’ acquaintance with the market, and have actually analyzed local government debt, but you are unlikely to read about them in Vanity Fair or see them interviewed on 60 Minutes offering a counterpoint to Whitney.  Why is that? 

As a postscript, someone should ask Whitney why she has not formally submitted an application to the Securities and Exchange Commission for NRSRO status.  (Remember how she was going to create a rating agency?)  The SEC would have to waive its requirement that ten large institutional investors pledge they have relied on Whitney’s credit analysis for three years.  Is she having trouble convincing the SEC to do so, or was she not sincere about establishing a rating agency in the first place?  Inquiring minds want to know.

The infrastructure investment component sounds great (using federal tax dollars to invest in anything that has a useful life would be nice), but Obama has delusions of grandeur if he thinks sizeable infrastructure projects can be undertaken quickly.  This was the reality of the American Recovery and Reinvestment Act, too.  Look at the transportation projects that ARRA actually funded.  According to the Federal Highway Administration, of the 13,333 projects funded, 49.7% were to repave existing roads; only 9.8% were for new construction (Bloomberg Municipal Market Brief, September 7, 2011).  It was not an accident that, despite the legislation’s green aspirations, we ended up improving one of the least green modes of transportation.  Paving roads is the low-hanging fruit in terms of projects that are ready to move forward (that are “shovel-ready,” if you will).  Large projects involve land acquisition, engineering, environmental issues, and many other legitimate pre-construction concerns, all of which are a challenge to expedite.  Add to this the fact that our nation has not had a long-term plan for making transportation improvements since SAFETEA-LU expired in 2009, and it becomes painfully obvious that the United States really is behind the curve on these kinds of endeavors.

The most obvious criticism of the legislation, however, when Obama outlined it conceptually, was that he had not devised a way to pay for it.  Instead, Obama indicated that he would direct Congress to enact offsetting measures (read: make politically unpopular spending cuts) because policymakers might unwittingly do his dirty work for him and let him take all the credit for a jobs package. 

It now appears that someone has pointed out to Obama that policymakers might not be all that selfless a bunch, because the administration has added some provisions to pay for the bill.  According to Bloomberg:

Jack Lew, the White House budget director, described the revenue-raising provisions, which were mostly pulled from previous administration budget proposals that haven’t passed Congress …

The biggest revenue-raising proposal in the jobs package, at $400 billion, would cap itemized deductions and some exemptions for individuals earning more than $200,000 a year and married couples earning more than $250,000, Lew said.

This would prohibit investors from using tax-exempt bond interest and other exclusions and deductions to reduce their income tax rates below 28%.  This would likely reduce demand for municipal bonds substantially – you know, the primary vehicle for infrastructure investment in this country.  According to the Bond Buyer, “Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher.”   Prices for outstanding municipal bonds will decline and borrowing costs for state and local governments will increase going forward.  This means state and local governments will have to levy more taxes to construct projects as planned, postpone projects, or cut spending elsewhere.

It continues to astound and disgust me how little our leaders understand the financial markets.

What was Operation Twist?

Operation Twist was a program executed jointly by the Federal Reserve and the (freshly elected) Kennedy Administration in the early 1960s to keep short-term rates unchanged and lower long-term interest rates (effectively “twisting” the yield curve). The US was in a recession at the time, but Europe was not and thus had higher interest rates.  Arbitrageurs (under the Bretton Woods system) would convert US dollars to gold and invest the proceeds in higher-yielding assets overseas (see Alon and Swanson, Operation Twist and the Effect of Large-Scale Asset Purchases).  Billions of dollars’ worth of gold was flowing into Europe each year.  (Incidentally, President Kennedy announced Operation Twist on February 2, 1961, which basically corresponded to the business cycle trough.)

The notion behind Operation Twist was that the government would encourage housing and business investment by lowering long-term rates and at least not encourage gold outflows by maintaining short-term rates.  Mechanically, the Federal Reserve kept the federal funds rate steady while purchasing longer-term Treasuries.  The Treasury reduced its issuance of longer-term debt and issued mostly short-term debt.

Did Operation Twist have the desired effect?

Most economists have regarded Operation Twist as a failure, primarily due to the research of Modigliani and Sutch.  (In his well-known paper, Monetary Policy at the Zero Bound: An Empirical Assessment, Bernanke devotes all of one paragraph to Operation Twist.)

Eric Swanson, an economist at the Federal Reserve Bank of San Francisco, published a paper earlier this year, Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2, comparing the magnitude of Operation Twist to the Fed’s second round of quantitative easing and examining bond market movements around six announcements related to the program.  (Modigliani and Sutch used quarterly data.)  While Swanson was able to demonstrate that Operation Twist had a statistically significant effect on longer-term Treasury yields, his estimate of the cumulative effect of the program did mirror that of Modigliani and Sutch. 

Over the course of Operation Twist, the Fed purchased $8.8 billion of Treasuries.  Swanson suggests that, while this amount may sound insignificant, it is comparable to QE2 if one looks at the size of the program as a percent of GDP (OT: 1.7% vs. QE2: 4.1%); as a percent of US Treasury debt (OT: 4.7% vs. QE2: 7.0%); and as a percent of Treasury-guaranteed debt (OT: 4.5% vs. QE2: 3.7%). 

Swanson also argues that because the Treasury functioned cooperatively with the Fed in implementing the program, Operation Twist was a larger endeavor than QE2.  For what it is worth, I have seen this sentiment contradicted elsewhere – see this article from the Bank of International Settlements Quarterly Review, June 2009, “Government debt management at low interest rates” – which indicated that a large fraction of Treasury issuance during the period was actually at maturities over 5 years and that the Fed only purchased long-term securities offered at dealers’ initiative rather than soliciting offerings, which reduced any potential impact on interest rates.  This seems like it would be uncontroversial to me, but Swanson did not provide that level of detail in his paper, and I am too lazy to try to replicate the data tonight…

(The issue that Treasury debt management and Fed policy could be at cross-purposes, however, seems worth considering.  The US Treasury has been actively trying to lengthen the average maturity of its marketable debt as a means of managing the government’s total interest expense and rollover / liquidity risk.  For a detailed discussion of this strategy, see the August Presentation to the Treasury Borrowing Advisory Committee.)

As far as the cumulative effect of Operation Twist, Swanson estimates it at around 15 bps.  (The spillover effect of the program was estimated at 13 bps for agency bonds and 2 to 4 bps for corporate bonds.)    Swanson writes:

One could argue that, at 15 basis points, the effect is not very important economically… However, it should be noted that a 15-bp decline in the 10-year Treasury yield would be a typical response to a 100-bp surprise cut in the federal funds rate target (Gürkaynak, Sack, and Swanson, 2005).  Such a change in the federal funds rate would usually be regarded as a non-negligible easing of financial market conditions.

Maybe, but in a world where Europe is imploding every two weeks, the significance of a 15-bp move is arguably lost.  Such a move would also be small compared to the flattening that has already occurred so far this year.  Nowadays, announcements of an innovative (or at least rarely utilized) program mostly seem to provide a temporary adrenaline rush for the lemmings in the equities markets, and that’s about it.

Pimco’s Bill Gross offered a direr outlook for the program in his Financial Times opinion piece, arguing that:

The front end of the curve has for all intents and purposes become inert and worst of all flat as opposed to steeply positive.  Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on.  A bank can no longer borrow short and lend two years longer at a profit…

By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming Operation Twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process.  The further out the Fed moves the zero bound towards a system-wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.

This is an extant problem, obviously, but it seems more likely (to me at least) that Operation Twist would have little effect at all.  (To his credit, Mr. Gross appears to be the only person actually considering the costs of such a program.)

A more interesting question is why we are even debating a monetary policy that most economists have regarded as a failure for decades.  Most Americans have come to regard their government as completely dysfunctional and have written off the possibility of policymakers ever reaching a consensus on even trivial operational matters let alone how to revive the economy.  Policymakers and those vying to be president have nonsensical economic opinions that are rooted more in myth and fantasy than empirical analysis. It might be more efficient to put lobbyists in a boxing ring and cut out the middlemen.

I am not trying to be cynical here.  This is a tragic and dangerous position for our country to be in.  At some point, however, we have to acknowledge that the Federal Reserve cannot compensate for the leadership void in this country just because it is the only body that can actually make decisions.  The duration of the Fed’s portfolio is not what is standing between us and economic prosperity.  Get real, people.