Unless he can get California's debt under control, Governor Arnold Schwarzenegger may soon have an enemy more fearsome than the Predator, the T-1000 or anything else he battled in the movies.
Rather than a make-believe beast, the Governator is in the sights of the very real and very powerful bond market vigilantes.
These are the funds who stalk the $80-trillion global fixed income market, forcing unpleasant decisions on governments who don't have the stomach for real budget cuts. They had their way with Canada in the early 1990s and now are toying with Greece.
But they are already eyeing new targets. They are watching California, as they are Michigan, New Jersey, New York and other states that have been piling up debt. Positions in credit default swaps on state bonds are building as bondholders and speculators place their bets.
In some respects, it's easy pickings.
The cause of the states' predicament is easy to spot: plunging tax revenue from a recession and burst housing bubble has left income far short of spending. States have been working to cut outlays, with California even slashing funding to its treasured state university system, but it's not happening fast enough. There are few options, given that some states have limited powers to increase taxes.
Deficits at the state level now total around $290-billion (U.S.), according to analysts at Hedgeye Risk Management LLC. What's more, there are about $1-trillion more in unfunded pension liabilities. To Hedgeye, states are looking a lot like the PIIGS - Portugal, Italy, Ireland, Greece and Spain and investors have every right to be concerned.
Few people seem to really believe that actual defaults are in the pipeline. That general feeling that countries just don't default any more flies in the face of recent research to suggest that defaults by sovereign nations and states move in cycles, and given that they are at a low, the only direction is up. Europe is on the firing line now, but the U.S. states may be next.
"It's no longer a tail risk, it's right in front of you," Keith McCullough, head of Hedgeye, told his paying clients Friday in a conference call. "It's coming to a market near you."
The risk is becoming apparent in the credit default swap market, made famous in the Greek blowup. What that market shows is that California is in big trouble, and other states aren't far behind.
Credit default swaps (CDSs) allow investors and speculators to buy insurance against a default by a bond issuer. The bigger the risk, the higher the price. Just as insurance on a house with bad wiring is more costly, protection on a country with weak finances is more expensive.
The market in state and municipal CDSs is very small, but the trends are telling. First off, the amount of insurance being purchased is on the rise.
States are beginning to show up on the Depository Trust and Clearing Corp.'s list of the busiest 1,000 entities for CDS trading.
The number of credit default swap contracts outstanding on bonds of states like California, Florida, New Jersey, Texas and Florida has steadily been ticking upward in recent weeks, according to the DTCC, and those five states now have a total of almost $17-billion (U.S.) of CDS contracts outstanding on their bonds. About 40 per cent of that insurance is on California bonds.
(For some perspective on just how small the market still is, that tally is still only a little more than a quarter of the DTCC's total for Goldman Sachs. But stay tuned.)
The price movements are also revealing, as buyers of insurance on some state bonds pay premiums that are approaching those of Greece.
The key level seems to be when premiums to insure $10-million of bonds (the standard size for quoting a price) top $300,000 a year, according to Hedgeye. When insurance tops that price, look out. It was a red flag for the Lehman Brothers Holdings Inc. situation and for the Bear Stearns mess.
Insuring $10-million of Greek five-year bonds would cost about $342,000 a year, according to CMA Datavision.
California topped $300,000 a year last month, according to Bloomberg. Other states with messy finances, including Michigan, New Jersey and New York (not to mention New York City), all peaked above $210,000 during the worst fears about Greece.
Prices on state insurance have come down, but maybe not for long. Mr. McCullough argues that investors are being too complacent as they unwittingly enter "unchartered waters." Sovereign debt defaults are "a real cycle that has just started as opposed to just ending because some people think Greece issues are in the rear view."
To hear Mr. McCullough tell it, the size of the risk has some uncomfortable parallels.
"It looks a lot like 2007, but this time instead of LBOs and Wall Street bankers, the faces and the names have changed. Instead it's politicians and governments, and that can be much more frightening."
