How to Short Munis

By: John Rubino | Mon, Nov 22, 2010
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From Saturday's Wall Street Journal, more on the federal government's ongoing stealth bailout of US states:

States Raise Payroll Taxes to Repay Loans

Thirty one states, their unemployment-insurance funds empty, have borrowed nearly $41 billion from the federal government. California alone has borrowed nearly $8.8 billion as of mid-November, according to the Labor Department. As states try to replenish the funds and begin to repay the loans, employers are facing increases in both state and federal payroll taxes, a potential barrier to new hiring.

"Employers were hit with these adjustments quite a bit last year," said Richard Hobbie, executive director for the National Association of State Workforce Agencies. A National Employment Law Project analysis found 41 states increased unemployment-insurance payroll taxes this year by an average of nearly 33.9%. The largest was a 168.5% boost from 2009 in Hawaii.

States in the Red

Most states have addressed or still face gaps in their budgets, while tax revenue declined.

Payroll taxes levied by states fund unemployment benefits for up to 26 weeks -- and longer in some states. The federal government requires states to pay benefits even if their unemployment funds run out of cash. As in past periods of high joblessness, the federal government has paid for extended unemployment benefits, this time for as long as 99 weeks.

The unemployment-compensation system, initiated during the Great Depression, was designed so most states build reserves when jobs are plentiful and few workers are receiving benefits, and then draw down the reserves in bad times. But few states were prepared for a recession as deep and lasting as the recent one, with unemployment remaining at a historically high 9.6% a year after the economy resumed growing.

During the 2008-09 fiscal year, states collected $31 billion of unemployment-insurance taxes and spent $79.4 billion on jobless benefits. Taxes are typically levied on a per-worker basis.

Arizona, which owed the federal government $172.8 million as of mid-November, increased its tax on employers by more than 50% at the beginning of this year to an average of $145.60 a year per employee. "The dilemma we face is, how do you do that without hurting the economic recovery we all hope is coming?" said Steve Meissner, communications director for the Arizona Department of Economic Security.

Indiana Gov. Mitch Daniels proposed cutting unemployment benefits earlier this month despite his state's 10.1% unemployment rate. Indiana has borrowed nearly $1.9 billion from the federal government to shore up its unemployment-compensation fund; next year, the state is to begin taxing businesses more to replenish the coffers.

Federal loans to states have so far been interest-free under a provision in the Obama administration's 2009 fiscal-stimulus law. But that waiver expires in January.

Texas, which has borrowed nearly $1.6 billion from the federal government and raised employer taxes, is offering $1.1 billion in tax-exempt bonds to repay loans before Washington begins imposing interest charges because, said Ann Hatchitt, a spokeswoman for the Texas Workforce Commission. The state, which employed the same strategy in the early 2000s recession, figures it will pay investors less than it has to pay the federal government.

Time To Short Muni Bonds?

This looks a lot like the bailout that Ireland just got from the EU and IMF. But Ireland's troubles are front page news while California, Arizona and New York get their bailouts under the radar via already-existing programs like unemployment benefit extensions and Build America Bond subsidies. So the true magnitude of the state financial crisis is buried in hard-to-decipher Treasury Department line items. When and if someone adds it all up, the number will be shocking.

Perhaps in anticipation, munis got whacked last week, and now yield more than not just Treasury bonds, but some taxable corporate bonds. So munis might finally be interesting short candidates. Here are some ways to bet against them:

Muni ETFs and closed-end funds
Both ETFs and closed funds theoretically can be shorted like stocks. These days the "theoretically" is key, because finding shares to borrow and sell is no longer a given. But if the shares are available, shorting these funds is a fast, simple way to get broad short exposure. This strategy has a cost, however, since closed-end muni funds and ETFs pay dividends that a short seller must cover.

Closed End Muni Funds
Eaton Vance Municipal Bond Fund (EIM)
Van Kampen Trust for Investment Grade Municipals (VGM)
Eaton Vance Insured Municipal Bond (EIM)
Blackrock Municipal 2020 Term Trust (BKK)
MFS High Income Municipal Trust (CXE)
PIMCO California Municipal Income Fund III (PZC)

Long-Term Muni ETFs
iShares S&P National Municipal Bond Fund (MUB)
Market Vectors-Lehman Brothers AMT-Free Long Continuous Municipal Index (MLN)
PowerShares Insured National Municipal Bond Portfolio (PZA)
PowerShares Build America Bond Portfolio (BAB)
SPDR Lehman Municipal Bond ETF (TFI)

End-Date National Muni ETFs
iShares 2015 S&P AMT-Free Municipal Series (MUAD)
iShares 2016 S&P AMT-Free Municipal Series (MUAE)
iShares 2017 S&P AMT-Free Municipal Series (MUAF)

State-Specific Muni ETFs
iShares S&P California Municipal Bond Fund (CMF)
iShares S&P New York Municipal Bond Fund (NYF)

Muni credit default swaps
The hedge funds that made a killing on the housing bust did so mostly by buying credit default swaps (insurance that pays off in the event a bond defaults) on mortgage-backed bonds. Tthe muni version is available via the MCDX, an index containing 50 equally-weighted credit default swaps for major muni issuers.

Bond insurers
The insurance companies that guarantee the interest on less-than-stellar munis are on the hook if defaults exceed historical levels. AMBAC just filed for bankruptcy, leaving MBIA, Assured Guaranty, and Berkshire Hathaway as potential shorts.

Owners and underwriters
According to the Federal Reserve, commercial lenders have been steadily increasing their muni holdings in recent years, and now own bonds worth about $215 billion. The muni portfolios of Citigroup, State Street, and U.S. Bancorp, for instance, rose to 25-year highs in the first quarter. Several major banks, including Bank of America, Citigroup, and Barclays are also underwriters of munis.

Insurance companies, meanwhile, reportedly own about $450 billion of munis, with Travelers and American International Group owning $41 billion and $45 billion, respectively.



John Rubino

Author: John Rubino

John Rubino

John Rubino

John Rubino edits and has authored or co-authored five books, including The Money Bubble: What To Do Before It Pops, Clean Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar and How to Profit From It, and How to Profit from the Coming Real Estate Bust. After earning a Finance MBA from New York University, he spent the 1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst. During the 1990s he was a featured columnist with and a frequent contributor to Individual Investor, Online Investor, and Consumers Digest, among many other publications. He now writes for CFA Magazine.

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