Sunday, March 7, 2010

Currencies: the Latest Bubble to Burst. Is Municipal Debt Next?

In the leverage-fueled, easy money world of the turn of the 21st Century, life is just one asset bubble after another. The bubbles du jour are the Euro and the pound sterling. The Euro bloc and the U.K. seem to have achieved faux prosperity with gads of borrowed money, some of it carefully tucked away in quiet, little (or perhaps not so little) derivatives transactions.

But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.

Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.

They may take inspiration from the Chinese government. A news story today on ( reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.

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