Broke And Desperate, Part 1: Chicago Pawns A Crown Jewel

A new bond issue from Chicago is rated AAA. That's great because it means the city's finances are on the mend, right? 

Nope, just the opposite. Here's the story:

Bondholders fret as alchemy turns Chicago's junk to gold

(Bloomberg) — Chicago's public pension debt is $36 billion and growing, it's facing $550 million in budget deficits over the next three years and this summer the state had to bail out a school system that was flirting with insolvency.

Yet next month, the nation's third-largest city — whose bonds were downgraded to junk by Moody's Investors Service two years ago — will start selling as much as $3 billion of debt that another rating company considers as safe as U.S. Treasuries.

That's because Chicago is selling off its right to receive sales-tax revenue from Illinois to a separate public corporation, which will issue new bonds backed by those funds, a structure called securitization. Because bondholders will be insulated from the city's finances and have a legal claim to the sales-tax money, Fitch Ratings deems the bonds AAA.

Some investors fear Chicago's approach may kick off a wave of securitizations by fiscally stressed municipalities that would increase their risk by siphoning away cash that backs bonds secured only by a promise to repay. Last month, Connecticut, which had a $3.5 billion two-year deficit, approved a budget that authorizes new debt backed by state income tax so it could receive a higher rating than the state's A+ general-obligation bonds.

"You are, through a process of alchemy, creating AAA rated debt," said Christopher Dillon, a municipal bond portfolio specialist at T. Rowe Price Group Inc. "They've lowered their borrowing cost in the near term, but long term, it's just a continued degradation of the full faith and credit at the general-obligation level."

DETROIT CASTS A SHADOW
Since Detroit's bankruptcy four years ago, investors in the $3.8 trillion municipal market have given greater scrutiny to securities backed by a government's good word instead of a secure revenue stream. When that city emerged from court, holders of "limited" general-obligation bonds received 42 cents on the dollar for their investments, compared with 100 cents for owners of Detroit's water and sewer debt.

Institutional Investors from Pacific Investment Management Co. to Standish Mellon Asset Management Co. have said they favor revenue bonds, which don't compete for resources with public pensions, over general-obligation debt.

Creating separate entities to issue higher-rated debt isn't a new phenomenon. New York City, Philadelphia, Washington, Nassau County and Buffalo, New York, have all issued higher-rated dedicated-tax bonds to save money. But Chicago's sale comes as many cities face pressure from deeply underfunded pensions and opting for bankruptcy has lost some of its taint after a handful of governments did so after last decade's recession, though Illinois municipalities aren't allowed to take that step.

Chicago's new bondholders will have a first claim to more than 90 percent of the approximately $715 million of sales-tax revenue collected each year, according to a presentation to Chicago's aldermen. The state, which collects sales taxes, will send the revenue directly to the bond trustee. Any excess revenue will go to the city.

PUERTO RICO FIGHT
Some investors say the legal battle now being waged in federal court between Puerto Rico's general-obligation debt owners and sales-tax bondholders shows that legal structures like the one set up in Chicago are no guaranty when a borrower goes bankrupt or encounters severe financial distress.

In 2006, Puerto Rico passed a law creating a separate entity to issue sales-tax backed bonds with a legal structure similar to Chicago. The commonwealth approved a 5.5 percent sales tax and sent a portion to an entity known as Cofina. The new tax-backed bonds issued by the agency had a bigger margin of safety to pay debt service and garnered A+ ratings, five levels higher than Puerto Rico's general-obligation bonds at the time.

This year, Puerto Rico entered into a form of bankruptcy and Cofina bondholders discovered the debt might not be so secure.

In June, the island said it may need more than $400 million in sales-tax revenue held by Cofina's bond trustee for government operations. Cofina bondholders are fighting the move in bankruptcy court. General-obligation bondholders assert the money belongs to them, arguing that the territory's constitution guarantees them a first claim on the government's resources.

"We're seeing these structures don't always stand up the way they were designed to in bankruptcy," said Tamara Lowin, director of research at Belle Haven Investments. "The market's not putting as much faith in them as they have in the past."

Chicago will use the proceeds of the new bonds to pay off old, higher-coupon paper, thus cutting its overall interest costs for a little while. But since it runs a chronic deficit, it will soon be back in the market to borrow more, at which point it will have to pay up – since those AAA bonds are siphoning off so much money. Then the downward spiral will resume, with no more tricks available to delay the inevitable.

What happens then? A federal bailout, of course. This was always the end game for the dozens of cities and states that have never – even during a historic bull market in financial assets – managed to balance their promises to public sector unions with their ability to generate tax revenue.

The question is what all these "failed states" will do to confidence in central governments' ability to keep levitating the financial markets.

The "Other" Side of Asymmetry You Never Hear About

Everyone's heard of "The Big Short". We've Hollywood to thank for that, and thank them I will. After all, who didn't love Margot Robbie explaining how it all worked? Even Mrs. Chris liked her.

Of course, our heroes correctly bet against these mortgage backed securities smoking piles of isht and now they all drive Porsches and eat lobsters in their bathrobes.

Likewise, everyone's heard of Jesse Livermore's famous shorting of the 1907 and 1929 markets where he made a fortune — over a billion green ones in todays money, actually.

Then there's the legendary stories such as Paul Tudor Jones shorting into what was to become known as Black Monday in 1987, tripling his money.

Now, if you were to ask what defined these trades and made them different from any other, more often than not you'd be told that alot of money was made in a very short period of time, which in itself is unusual.

True, but that doesn't tell the whole story.

Dig further and ask what made it so, and you'd likely hear that the upside in the trades was high as opposed to say buying the Dow, taking a strong sedative, and waking up in 20 years.

All of these things are correct, but if you ask me this misses what is probably THE most important point that actually acts as a potential (note: I said potential, nothing is guaranteed) "tell" in any market. Bugger all downside risk. And this happens for very obvious reasons.

It actually comes back to what makes any market become over or undervalued in the extreme. In psychology it's known as the Dunning-Kruger effect or the cognitive bias in which individuals with low ability perceive themselves as having high ability. It is, in essence, overconfidence.

It was overconfidence that led Joe Sixpack to continue to buy real estate at prices which had become completely disconnected with the incomes that must support those prices, leading to the GFC.

It was overconfidence that led the pointy-shoed suits on Wall Street to package subprime mortgages up, believing that a pile of isht when added to other piles of isht through the magic of diversification turns isht into non isht. Many actually believed that. Overconfidence.

I see this at the big banks who construct ridiculously complex models to assess risk. I spoke about this in "VAR shocks" where I marvel at how they keep getting it wrong. A fair amount of blame must rest on the shoulders of overconfidence.

In fact, the most epic financial screw-ups in history have all been accompanied by overconfidence.

Remember LTCM?

Granted, I've never received a Nobel prize but if I ever did, I'd probably feel overconfident, strut my stuff, and do something monumentally stupid.

Like becoming so confident bond spreads couldn't widen beyond a certain point for a certain period of time that I'd throw all sensible position sizing out of the window and go all in. I'd probably do that just before a major crisis like the rubble collapse. It's why, if I ever make it onto the cover of Forbes or Time magazine, you should probably immediately unsubscribe or at least do the opposite of whatever it is I'm doing.

Over the weekend, I was thinking about where investors are confident today or indeed where they've completely lost confidence. So I set my skinny fingers to work and looked back at what's transpired in the last couple of decades to see if I could find a market where investors got completely hosed for getting it wrong.

And you know what smacked me like a pan on the face?

The standout winner: Shorting the JGB market.

It's not called the widow maker for nothing. This is one trade that has been just ideal for folks who like to be tied up and beaten for thrills.

Understandably there's not many of these guys left. If you want to hear a deafening silence, try this. Yell into a room full of hedgies, "who's short JGBs?"

Here's the 10-year Japan government bond yield curve:

We all know the math here. Heck every macro hedgie worth his salt has looked at and had a crack at this bad boy, including yours truly. Ouch!

Maybe the BOJ keeps buying the bond market until they own the whole damn thing. Maybe nobody cares. Maybe the yen doesn't even move after the bond market is completely owned by the BOJ. Maybe deflation is like stupidity: Here forever, no matter what.

Then again, maybe Harvey Weinstein's a loving husband and a nice guy.

What is unique about Japan is that the BOJ is targeting yield and holding the 10-year at zero. Not sub zero - just zero. This is important because as we now know yields can go negative, meaning shorting a bond that's trading at say 100 no longer means it can't trade at 109.

To illustrate my point just take a look at bunds.

At present, they're are as crazy as Heinz after you've nicked his beer and taken off with his daughter. We can see that the yield is negative all the way out to the 8-year.

And this is what makes JGBs kinda unique.

Theoretically, the floor is zero. Granted, this could change, but let's go with it for the minute. If your central bank tells you explicitly where the bond is going to trade at, then what the hell's the point in trading it?

To answer this, let me return to the beginning of this missive. What is it that most people miss when talking about massive payoff trades?

The answer is very, very low risk should the trade not pan out.

Sure, we all want big payoff trades, but the other side of asymmetry is our cost of entry and our risk if we screw it up. Well, let's return now to our sake drinking friends.

Due in no small part to the BOJ holding the 10-year yield at zero, volatility has lost all the bones in its body and collapsed. Nobody's playing anymore. Take a look: Implied volatility of 1.2%. That's basically free.

Which presents an interesting situation. The cost to short JGBs now is about as close to zero as we've ever gotten.

What I ask myself is this: Have the laws of economics been suspended indefinitely?

Because if we do the simple math (as so many fund managers have done for the last 20 years), we still realise that even more than ever with a debt to GDP of over 250% it's become so very important to ensure that nothing, and I mean nothing, moves rates on the BOJ.

Because if it did. Well...

Right now, everyone has given up on this trade, except the two guys with balls in their mouth. The world is fragmenting politically,and the BOJ has pegged the bond market. And if there's one thing history teaches us, it is that all pegs break at some point.

Right now, there are multiple indicators showing both stress in bond markets and rising inflation.

What happens if the tiniest bit of inflation creeps in and the BOJ attempts foolishly to keep the peg?

Well, it'll mean a godawful amount of yen printing to keep the short end of the curve under control. But the printing of yen can quickly lead to an inflationary feedback loop, especially given that all maturities would come under pressure and this would mean the BOJ would be firefighting across maturities. More printing of yen, more feedback loop. Kaboom!

Hmmm....

Something to think about. And it's close to free.

"All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis." — J. Livermore

What Central Banks Have Done Is What They're Actually Good At

As a natural progression from the analysis of one historical bond "bubble" to the latest, it's statements like the one below that ironically help it continue. One primary manifestation of low Treasury rates is the deepening mistrust constantly fomented in markets by the media equivalent of the boy who cries recovery.
That narrative "has ruffled a few feathers," BMO Capital Markets strategists Ian Lyngen and Aaron Kohli wrote in a note last week.





"Growth is moving at a solid clip and the labor market is ostensibly at full employment — so why aren't we in an environment with a steeper curve and higher yields?"

If solid growth plus full employment equals a steeper yield curve and higher long rates, and they do, then a flatter curve at lower nominal rates must then equal what?





The answer is far easier than the media makes it out to be. In what is pure Aristotelian sophistry, they try very hard to ignore their own logic where the answer to this "conundrum" is clearly choppy, lackluster growth that has left the (global) economy considerable hangover slack.



That's what the yield curve continues to say, the only thing it has said for many years now.

It's amazing that after more than a decade now of these markets (UST's, eurodollar futures, swaps, FX, etc.) declaring that "something" is wrong how easily it is for these people to simply set it all aside because their highly optimistic view on the economy, derived exclusively from central bank forecasts and actions, just has to be right. They are actually saying that markets need to conform to their opinions without evidence, and without recognizing the market prices are evidence, as if theirs is the only correct possibility.

Time plays a significant component of that backwards view because it is extremely hard to believe the global economy could ever be stuck in such an awful place for so long.

It just seems so impossible, completely out of our own experience. Even if by random luck you would think enough would have gone right in just monetary policy by now that what is claimed for the economy in the mainstream might actually have come true. But this set of circumstances is not absent from all experience, just the modern one.


















The point of failure is right where it shouldn't be. That's what's making it so difficult. Even the bond market (as eurodollar futures and the rest) is declaring this to be the case. The issue is central banks and central bankers who have done nothing right, failed to achieve any positive offsets, and left the global economy to stand naked against the intermittent forces (three so far) of negative monetary decay.











So the real problem in the mainstream is over who to believe; the central bank technocrats who most people have been thoroughly schooled to trust without question, or these markets where actual discipline is the order of operation?

As hard as it may be to believe, I once gave central bankers the benefit of the doubt, too (though perhaps not as stridently as some still today). I had come to expect in early 2007 that the Fed, though clearly behind the curve, would catch up and fix the problem before it got out hand. Greenspan's reputation had lost a lot of luster in my eyes as a result of lingering unanswered questions about the dot-com era and "jobless recovery" after that (mild) recession, but surely he wasn't grossly incompetent. He couldn't have been, could he?

It was really difficult to accept that it was all smoke and mirrors, one of those viral kind of things where you tend to believe something is true simply (solely) because everyone else does. It becomes such hardened "fact" that to even think about challenging it makes people wonder what's wrong with you. The wisdom of the crowd is perhaps just as often that sort of mass delusion wrapped in an impenetrable bubble.

Then August 9 happened, and similar days happened afterward in repeating fashion. Then 2008. That should have been more than enough to dispel any notions of competence on any subject related and not; monetary as well as economic. The panic itself and the enormous global economic consequences should have ended Economics.

They really don't know what they are doing. They never have. The central bank holds only one specialty to which it is any good, a capability that Milton Friedman pointed out in one of the last interviews he ever gave more than a decade ago just prior to the onset of all this trouble.



The difficulty of having people understand monetary theory is very simple - the central banks are good at press relations. The central banks hire people and the central banks employ a large fraction of all economists so there is a bias to tell the case - the story - in a way that is favorable to the central banks.



But the Great Depression was such a major event and such a disaster that there was no way in which you could talk it away, although they tried to do so. If you read the annual reports of the Federal Reserve Board or its testimony before Congress, you will find that as late as 1933, at the very depths of the depression, it's talking about how much worse things would have been if the Fed hadn't behaved so well. [emphasis added]

Central bankers simply did it again.

What was Ben Bernanke's message at the end of 2008? He was no longer talking about prevention, as had been standard up until Lehman, and accounting for what he had done prior.

Bernanke simply began speaking and writing and televising exclusively about "jobs saved", what the Fed was going to do in the future to cushion the blow that was then some devious, exogenous factor no reasonable person could ever think to blame monetary officials about. No longer would there be much about the past, what they had done prior. All the world's central banks were suddenly victims, too.







And like the thirties, it was all BS.

But "we" let them off the hook to write their books, revise the official history of the crisis so that somehow they come off the heroes when they were seriously, perhaps criminally, as well as obviously (when you look), derelict. The degree of gross incompetence was absolutely staggering – and it never ceased. You require no special training to easily understand that if as a central banker you "need" a second QE (let alone a third or fourth) the whole thing just doesn't work (how can it be "quantitative" if you don't know the right quantity?)







Central banks are the epitome of PR and media manipulation. And that's all they are, certainly no money in monetary policy. They've done such a masterful job of it that even today no matter how much market data disagrees, people just refuse to believe it.

'Hindenburg Omen' Meets 'Titanic Syndrome' For The First Time Since October 2007

Few weeks ago we warned that a cluster of the infamous Hindenburg Omens was forming. Since then stocks have suffered their biggest drop in 3 months...

However, the Hindenberg Omen is not exactly flawless and has false-alerted a number of times in the last few years.

Which is why, J. Hussman has adapted the signals and is now warning of a very significant convergence of the 'Hindenberg Omen' and the 'Titanic Syndrome'...

I've noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.

– J. P. Hussman, Ph.D., Market Internals Go Negative, July 30, 2007

Just a brief comment on market action.

On Tuesday November 14, the number of NYSE stocks setting new 52-week lows surged above the number of stocks setting new highs, with both figures representing more than 3% of total issues traded.

This "leadership reversal" joins the deterioration in our own measures of market internals last week, as well as ongoing dispersion in market breadth and participation.

As noted in the chart below, this couples a "Hindenburg" with a "Titanic," and is actually the first time since July 2007 that we've seen this particular combination of internal deterioration. Each of the red bars below was also associated with unfavorable market internals on our own measures.

While the names of these indicators may seem silly and overly menacing, they actually get at something very serious.

They capture situations where the major indices are near new highs, yet market internals show much greater divergence. In my view, this type of market behavior is indicative of a subtle shift in the preferences of investors, away from speculation and toward risk-aversion. Coupled with the most extreme "overvalued, overbought, overbullish" syndromes on record, the behavior of market internals warrants close attention. Credit spreads are also worth monitoring, as junk bond yields have surged in recent days.

Importantly, we always have to allow for the possibility that market internals will recruit fresh strength. Our measures of internals reflect current, observable conditions, and suggest increasing investor risk-aversion, but this deterioration is not a "lock" on a negative outlook. We'll take the evidence as it arrives, but today's leadership reversal seems worth noting in the context of the other internal deterioration we've observed in recent days.

As a sidenote, if we expand the window for a leadership reversal to within 10 days of a 12-month high instead of 7 days, there would be one additional signal on the chart above, in October 2007.

That was also notable in the context of broader internal deterioration, including three "confirmed" Hindenburg signals on Peter Eliades' criteria (which are more stringent than signals based on new highs and lows alone). Taken alone, I've often observed that signals like Hindenburgs and Titanics aren't nearly as ominous as they sound. However, they are more informative when they are coupled with broader evidence of internal deterioration, particularly following extended periods of overvalued, overbought, overbullish market conditions.

As noted in real-time, just after the what turned out, in hindsight, to be the 2007 peak:

Though I wouldn't take the 3 consecutive signals last week as a compelling warning in themselves, I do think they deserve mention because they are occurring so close to unusually overvalued, overbought, overbullish conditions that independently warranted concern last week. With regard to our own measures relating to new highs and new lows, we observed a 'leadership reversal' last week – a sudden flip from new highs dominating to new lows dominating, with significant numbers of both, within a few days of a market peak. Those reversals are generally a signal that there is an underlying "turbulence" in market internals, which is a symptom of increasing skittishness by investors.

– J. P. Hussman Ph.D., Forget the Lesson, Learn it Twice, October 22, 2007