Sunday, August 09, 2015

Who Is Buying That Crap?

Dan and I follow municipal bonds, which is a bit more exciting than it sounds. The State of Illinois, the City of Chicago, Cook County, and many other entities in which I am an semi-unwitting participant will likely soon be on the front pages of newspapers as it sinks in that we can never repay these debts.

Back in late 2008, during the height of that financial crisis, the State of Illinois issued debt. In this post I basically asked the question "Who is buying this crap?" and the answer was JP Morgan, showing its solidarity (in a way) with the state of Illinois by buying the ENTIRE issue.

Puerto Rico is the new problem child of debt failure, and as Dan calls it, a "gapers block" over the entire municipal debt market. There were a lot of good reasons to buy Puerto Rico municipal bonds for many years - it was tax exempt, it had high yields, some of it was insured and / or tied to revenue streams like power or water, and historically there had been few or no failures of large-scale municipal bond issuers. It was great to own this debt and collect the high interest rates, as long as you watched it and got out before it collapsed. In a way this is "momentum investing" of sorts - get in and enjoy the ride up, but make sure you clear the exit before the everyone else runs out of the movie theater screaming "fire".

But the question in the back of my mind was always "Who is buying that crap". Not sophisticated investors who knew how to ride the wave up and get out before it collapsed, but people who honestly believed that a set of statements by politicians and / or laws as they were currently constructed would magically allow a tiny and impoverished island to pay inordinate debts while their economy imploded around them.

A recent NY Times article titled "Pain of Puerto Rico’s Debt Crisis Is Weighing on the Little Guy, Too" provided a timely answer to my question.
To Lev Steinberg, it seemed like a good place to park his nest egg. Puerto Rico bonds offered high returns and tax-free income. And there was little chance, his broker assured him, that the government would default on its debt. So Mr. Steinberg went all in, investing more than 85 percent of his retirement savings in funds with large concentrations of Puerto Rico bonds.“They told me this was safe,” said Mr. Steinberg, a 64-year-old mathematics professor at the University of Puerto Rico, “that the legal protections to repay the bonds were strong.”
The NY Times article describes how local brokers and banks created products that leveraged up these bonds with borrowed money and then they were sold to Puerto Rico citizens (they were illegal on the mainland). The article said that 20% of Puerto Rican debt is owed to local citizens, and they bought many of the most "toxic" issuances (those with the least protections, like pension obligation bonds).

Thank you, NY Times, for helping to answer the timeless question "who is buying that crap". The answer is gullible citizens, who believed in their government's promises, and also thought that years and years of high returns could be manufactured endlessly out of thin air without corresponding risk.

Cross posted at Chicago Boyz

No comments: