We get called contrarian often enough that we’re nearly resigned to the label. From our perspective, of course, we’re not contrarians at all. We’re so deficient when it comes to having a decent respect for the opinions of mankind that we aren’t even aware of the prevalence or rarity of the positions we take. If we seem contrarian, we suspect it’s just because so many others are wrong so often.
The debate over municipal bond ratings is a good example of this. Over at Portfolio—published out of an august tower located in Times Square—they are convinced that Moody’s, Fitch and the like assign ratings that are too low to municipal bonds. This supposedly forces our towns, cities and states to pay higher interest rates or purchase bond insurance to achieve higher ratings. Jesse Eisinger, who holds the esteemed title of Senior Writer at Portfolio, estimates that this costs municipalities around $5 billion a year.
Like so many other errant theories about the world, the Eisinger Thesis (as we’ll call it) starts with a grain of truth. Municipal bonds do get lower ratings than their chances of defaulting would earn them if they were corporate bonds. The ratings agencies acknowledge that munis are rated relative to other munis, and will even provide ratings for munis on the corporate scale if asked. Few municipalities do request this, however, because investors in municipal bonds are interested in risk comparisons between different members of the muni asset class and not so much in comparisons to corporate bonds .
But from this grain of truth, the Eisinger Thesis attempts to build an imaginary sandcastle of scandal, mispricing and collusion. What’s so implausible about the Eisinger Thesis is that it requires us to believe that the markets are radically inefficient when it comes to pricing municipal bonds. It asks us to believe that bond investors are unaware of very public facts—including the use of different ratings scales and the fact that the ten year cumulative default rate of muni bonds rated Baa is less than that of AAA rated corporate bonds. Only by assuming that investors are ignorant of these facts can Eisinger conclude that muni bonds are mispriced.
You can see the absurdity of this. Even if the unwashed were a ignorant as Eisinger believes, surely the publication of this alleged mispricing in a prominent business magazine should help alleviate the predicament. How notorious does a widespread error have to be before we can conclude that it is well known enough to be taken into account by the markets?
We’ll give the last word, however, to James Bianco, the president of Bianco Research and himself a famed contrarian. He agrees that the Eisinger Thesis depends on the belief that markets are radically inefficient for muni pricing. He departs from us only by embracing that belief.
“The market has been mispricing munis for decades based on the assignments of the rating agencies. If the market was properly pricing munis, bond insurance would not exist. It exists because this market is highly inefficient,” he writes.
Can it be that we've gone so far over the edge of contrarianism that we're contrary to the contrarians? Does that make us spokesmen for the conventional wisdom? If DealBreaker is conventional wisdom, things are far worse than we feared.
Posted by guest , Feb 27, 2008 1:52PM
when you say "we", who do you mean? just asking...
Posted by guest , Feb 27, 2008 1:58PM
Why do you have such a hard time accepting innefficiency in the muni market? Muni demand is still mostly retail...retail investors are willing to overpay for wrapped 'AAA' bonds if it helps them sleep better at night. I would argue that the retail investor base of munis does not in fact know that the "ten year cumulative default rate of muni bonds rated Baa is less than that of AAA rated corporate bonds."
Posted by guest , Feb 27, 2008 2:24PM
Watching you and the monkeys at Portfolio spill ink over this is like watching the retarded kids fighting each other during recess.
This whole issue is discussed ad nauseum in this Federal Reserve research paper; it really isn't that complicated:
www.federalreserve.gov/pubs/feds/2005/200535/200535pap.pdf
Recess is over, you retards! Back on the short bus, pronto!
Posted by guest , Feb 27, 2008 2:28PM
"This leads supposedly forces"
?
Posted by guest , Feb 27, 2008 2:32PM
@ 1:58
It doesn't matter if the majority of muni demand is retail, what matters is the marginal buyers - they determine the ultimate price. If Baa munis were selling for significantly less than AAA corporates, astute wealth managers would surely get their clients in to capture the extra yield.
Posted by guest , Feb 27, 2008 2:40PM
the same "astute wealth managers" who assumed that auction-rate munis were as liquid as cash, and parked their clients' wealth there?
Posted by guest , Feb 27, 2008 2:40PM
Muni's are issued by little cities that "may" have a CPA running its CFO slot. They are not exactly your average wall street egg head. They may issue bonds once a year or less. They basically do what they are told is the "best advice" given to them by the street.
To say that they understand what they are doing in the bond area compared to say, the bond houses, is a farce. These people on average spend about 1 hour per month maybe... and I say Maybe worrying about their bond exposure.
They don't know how "NOT" to be screwed by wall street, let alone how to get a better deal then they are getting. I had the local City Manager ask his CFO about his exposure to monoline's. He didn't know what his city is rated at with out insurance. He heard Monolines were bad but didn't know what they actually were.
These people are worried about running their city, not about how many BPS they over paid in AAA coverage costs.
Find a new horse to beat on, those who work in the muni field understand what has been going on for decades, if you have not worked on a muni bond desk yourself, why are you continuously defending the streets actions?
Is this whole series of posts/counter posts some kind of pissing contest between yourself and Portfolio Mag? The barbs appear to be personally related, and not actually based on investigating reality...
Posted by guest , Feb 27, 2008 2:48PM
Too much freedom to blab that's the issue here.
Posted by guest , Feb 27, 2008 3:00PM
"If we seem contrarian, we suspect it’s just because so many others are wrong so often."
oh my heavens Saint Carney get OVER yourself will you? did you even have someone read this before you published it to make sure you don't come off sounding like a Schwartzman?
Posted by Anal_yst , Feb 27, 2008 3:04PM
Friend of mine works @ a Muni Arb fund which I'd never even heard of till I met him, managing a few BN$, returning ~10-15% after-tax each year. While its a massive leap to conclude that there must be massive inefficiencies in the muni market based on those returns, it is an indicator which supports that theory...
Posted by byrneseyeview , Feb 27, 2008 3:16PM
Anal:
I logged in to ask why nobody is doing just that. If this discrepancy really existed, one would expect every single non-wrapped, non-AAA muni to be bought up by arbs.
Posted by John Carney , Feb 27, 2008 3:16PM
Only 39% of munis are held directly by individual investors. There are lots of large investors in the market that we would expect are sophisticated enough to have encountered Fitch's 1999 study showing low default rates for munis.
Posted by miami , Feb 27, 2008 3:20PM
Anal,
Leverage is great until the day it blows up in your face. Lots of managers put together 10-15% after-tax returns [or just hold the fund in your IRA, no taxes!] using leverage.
One day his shorts will rise and his longs will fall. Take a look at any muni Arb fund or desk circa spring 1994 for more details.
Feel free to give us the delevered return of said Arb fund.
Posted by guest , Feb 27, 2008 3:27PM
I am always amazed how whenever anyone on this site mentions the performance on any fund or manager, if it is positive there is always someone there to say it is a stupid strategy and/or said manager is just lucky when that is not even the point of the foregoing comment.
Yes, miami, many arbs sometimes go in reverse that does not mean that the rest of the time the market is completely efficient. 2007 was a pretty rough year for merger arb does not mean that all mergers are priced efficiently.
Posted by Anal_yst , Feb 27, 2008 3:29PM
@ Miami
I hafta check but if memory serves that is the delevered return. I'll see if I can get some actual #'s to post, butt just to clarify, I'm not promoting the fund whatsoever just relating the information.
Posted by guest , Feb 27, 2008 3:34PM
Miami is just upset that all of his HNW clients' condos are in foreclosure and they cannot pay his commissions anymore
Posted by guest , Feb 27, 2008 3:36PM
@3:34 The quality of his post makes me think that miami is smart enough not be be dinged by such things.
Posted by Master of None , Feb 27, 2008 3:57PM
@3:36
I think by the "quality" of Miami's post you mean his flippant and arbitrary statements about the "inevitable" normalization of leveraged returns.
Well, it's not "inevitable" if you're right more often than you are wrong. Miami's incredulity towards that possibility suggests resignation to mediocrity. High quality indeed.
Posted by Anal_yst , Feb 27, 2008 4:03PM
Ok just got some of the fund materials, essentially they're arbing the relative steepness of the yield curves between (similarly rated) corporate and taxfree bonds, fully hedged, but borrowing ST to invest LT, so its not pure leverage in the traditional sense of the word, butt returns are ~ 1% monthly for the past 6 or so years.
Posted by diablo , Feb 27, 2008 4:12PM
Look at these charts of Vang muni funds prices compared to treasuries of about the same duration:
http://finance.yahoo.com/charts#chart1:symbol=vilpx;range=20070801,20080226;compare=vwltx+vfitx;indicator=volume;charttype=line;crosshair=on;logscale=on;source=undefined
The VFITX fund is intermediate term treasuries (SEC Yield 2.96%), VILPX is Insured Long-Term munis (SEC Yield 3.97%) and VWLTX plain Long-Term munis (SEC Yield 3.86%). Those yields are out of whack.
Then look at the chart and see what happened in August, November, January and now. Those curves should track the treasuries as they used to before August. Crazy stuff but if the market has some efficiency left, those muni fund prices scream of a huge buying opportunity. (Part of the blame here goes to the auction-rate securities fiasco, and tender option bonds, and other issues with monolines).
Posted by guest , Feb 27, 2008 4:15PM
You lost me here. Are there really that many opportunities in the relative steepness of the two yield curves to generate that type of return? Without say shorting one, which would be leverage...
Posted by guest , Feb 27, 2008 4:16PM
No one is saying it's a radical inefficiency -- 0.2% a year hardly qualifies as a massive gap -- just a real one. And John, you still haven't explained how this particular inefficiency is supposed to be arbitraged away. Go long AAA munis and short AAA corporate bonds? How long would it take for you to make significant money waiting for AAA corporates to blow up? A long time. And is the 0.2% risk-free return you're getting, even leveraged, worth the trouble?
Lay out your strategy for arbitraging this inefficiency away, and then we'll accept that you're right. And don't answer that surely someone on Wall Street is smart enough to figure it out even if you aren't -- because no one has.
Posted by guest , Feb 27, 2008 4:32PM
Miami @ 320
"One day his shorts will rise and his longs will fall".
How exactly do you short munis? Please call me from your jail cell to discuss.
Posted by guest , Feb 27, 2008 4:33PM
@3:36 beg to differ. At this point every college junior who is thinking about maybe applying for summer banking internships has read the wall street journal enough to know there is something out there called "leverage" and it has become very bad.
Posted by guest , Feb 27, 2008 4:38PM
@4:03 okay so that sounds like its not based on a credit arbitrage at all but rather a technical play on the historic shape of these curves and how they roll down, which is certainly a valid strategy and really there is a case you could employ a strategy like this (and many do) with any set of bonds where you can demonstrate an empirical correlation over time.
or am i missing something there?
Posted by John Carney , Feb 27, 2008 4:43PM
@4:32,
Shorting munis used to be nigh-impossible. Not anymore, now that we can short a muni ETF.
Posted by Anal_yst , Feb 27, 2008 4:45PM
@ 4:38
Pretty much, using Tender Option Bonds to borrow ST, long LT expands returns, with low correlation to equities, fixed income (on the whole). As explained, which makes sense, the size of the muni market leaves alot of opportunities for mispricing, and with a big enough fund (or enough leverage) you can earn good returns...of course if their swap hedges blowup they're SOL, butt thats another discussion
Posted by guest , Feb 27, 2008 4:47PM
John I think we can safely say based on Anal_yst's description that this is definitely NOT the strategy.
I don't even care to contemplate the difficulties of trying to generate meaningful alpha owning cash muni bonds and shorting the ETF what a nightmare
Posted by guest , Feb 27, 2008 4:50PM
Haha very clever well i'm not willing to commit that they have built a better mousetrap but as far as carry trades go you could certainly do a lot worse, and certainly a lot less creatively
Posted by miami , Feb 27, 2008 4:52PM
Anal,
Borrowing short to invest long most certainly is 'leverage.' I don't see how you could possibly dispute that definition. Whether they 'hedge' appropriately or not is a totally different issue.
Not surprisingly, your friend's fund's inception is post- the last big muni fund blowup. I'm sure he did fine over the past 6 years, although we have not seen his unlevered results. 12% with ~10% leverage is great, with 5x, not so much.
DMF has returned 14% annually [last I checked], but with 4-6x leverage.
'arbs sometimes go in reverse that does not mean that the rest of the time the market is completely efficient. '
Wow, thanks for elucidating a silly strawman that wasn't under discussion, guest! I can't wait to hear about the first time you pass your reading comprehension exam. You mean the markets aren't 100% efficient, O M F G!1!
FTR, I'm on the buy-side, not the sell side. But unbelievably stupid, backwards assertions by randoms on this site make it even funnier from time to time. Almost as funny as the 23-yr old Einsteins above who think it's News that Munis are not perfectly efficient.
Posted by miami , Feb 27, 2008 5:01PM
There are several muni indices that can be shorted by HFs or others.
A GS or Citi or LB would have no problem doing a swap on the returns of a liquid individual name/ basket of names/cusips with any sizable HF they deal with.
The roll down the curve trade has been around and used by hedge funds for a long, long time. There are obvious, structural inefficiencies there which aren't going away, as just one example. Leverage there continues to enhance returns and increase risk and kurtosis.
Posted by Anal_yst , Feb 27, 2008 5:01PM
@ Miami
poorly worded on my part, butt I agree with you, and I certainly won't pretend to be any sort of expert on Muni arb for what its worth, as, well, I'm not at all.
Posted by guest , Feb 27, 2008 5:10PM
@miami don't be a douchebag
"One day his shorts will rise and his longs will fall. Take a look at any muni Arb fund or desk circa spring 1994 for more details."
Your argument that an arb strategy is invalue just because it blew up once in 1994 is absurd in the extreme. Guest @ 3:27 is right to question you if that was your answer to Anal_yst that a hedge fund making money on an arb is not a fair point to indicate there is an inefficiency.
Posted by guest , Feb 27, 2008 5:13PM
let me state that I know next to nothing about finance, leverage, arb strat, etc. However, it seems to me that investment strategies that are used in the equity and corporate bond world can't be used in muni world because: of laws, rules & regualtions; because munis don't trade like stocks or corporate bonds; because large amounts of munis are held by widows and orphans who hold their munis until maturity; said widows and orphans like to hear that their bonds are insured even though the county has AAA rating. Finally, to the Dealbreaker writers, if you really have any experience in finane or pay attention to the news, how can you still beleive that markets are efficient? Honestly, its a nice theory but throwing those darts at the wall won't pay the rent.
Posted by guest , Feb 27, 2008 5:16PM
The guy (Anal) says there is some proof that muni market is inefficient, a question that is the topic of this entire post, and you jump all over him. Maybe if you were trying to agree with him you ought to have communicated that more clearly as opposed to being rude and confrontational, it is unclear what you hoped to get across other than that. The frequent commenter is usually pretty respectful, your aggressive posturing is unnecessary.
Posted by John Carney , Feb 27, 2008 10:47PM
@4:16 PM:
If the mispricing argument is correct, munis offer risk-free excess returns. I would have thought this would be clear. Mispricing would mean that munis pay more interest than is justified by their risk levels. And, yes, I think that given the size of the muni market and the number of muni investors and potential muni investors, this excess return would generate enough additional demand that interest rates would decrease.
I'm not sure why you are even bringing in these more complicated structures. My point is that the mispricing thesis posits that excess returns are available, and this can fairly be described as risk free yield (it is yield that is available without accepting additional risk).
I take you now agree with me. Welcome aboard.
Posted by diablo , Mar 03, 2008 6:34AM
A rating agency get paid (again) after a muni gets insurance. So if the original rating was A (rating agency got paid for that), then the muni gets wrapped on the monoline rating (AAA), the rating agency gets paid again, and just for the wrap.
http://www.nakedcapitalism.com/2008/03/rating-agency-conflicts-in-munis-coming.html
Posted by guest , Mar 22, 2008 5:33PM
http://www.bloomberg.com/apps/news?pid=20601109&sid=apn3INgBg5bY&refer=home
Hummmm sometimes reality is reality, even if Juan Blarney is blind to it... ;-)