Thursday, June 14, 2012

Will municipal bonds be the next headwind on the horizon for Jamie Dimon and JP Morgan?

Update: This article is also appearing at Global Economic Intersection.
Update: June 19th, 2012: "Report: Maryland, Virginia pension underfunding 'cause for serious concern" from the Washington Examiner

Will an allegedly unpublished research report on the impending dangers of the exploding size of state, city and local government unfunded pension liabilities put JP Morgan and Jamie Dimon back into the cross-hairs of regulators and legislators?

Reported by Charlie Gasparino of Fox News yesterday afternoon: According to Gasparino it's not so much about what the report said but that these facts were apparently known by the firm at the same time JP Morgan bankers were bringing some of these same problem issuers to market with no disclosure to investors of the existence of the report or its findings.

At the same time this report also helps to vindicate Meredith Whitney who was widely derided for her call back in December 2010 when she predicted that municipal fiscal mismanagement would lead to massively underfunded pension plans on the state and local level that, coupled with a struggling economy, would ultimately result in a large number of big name municipal defaults across the country.

As a bond analyst in my first job out of business school 10 or so years after the Municipal Assistance Corporation was created to keep New York City afloat, I learned that it doesn't take the computer aided analysis available today to understand that the current economic landscape and underfunded pension plans existing in conjunction with an outsized growth trajectory in future obligations is a recipe for fiscal disaster.

A better question might actually be why Meredith Whitney and this unpublished report from JP Morgan directly address this issue while the majority of the rest of the Wall Street analysts dispute them or minimize the risks? Could this be due to any of the following?

1) The money firms make as bankers on deals,
2) Potential public panic if the underlying viability and safety of this trillion dollar-plus market that serves as a staple investment for "widows and orphans" were to be seriously called into question by analysts across Wall Street,
3) A spike in municipal borrowing costs as the actual and perceived risks caused investors to demand higher returns at exactly the time the issuers can least afford to pay for it,
4) Fixed income investors pulling back in their purchases of individual muni bonds and tax-free bond funds opting instead for much lower margin investments such money market funds until the issue is clarified. Once again this reason would be all about the bottom-line of the firms, or
5) All of the above

As an aside #3 is the same risk faced by the US government only for treasury securities.

Charlie Gasparino on Fox Business News

Watching the Jamie Dimon testimony before Congress yesterday I was struck by the clarity of the witness and by the apparent ignorance of many of those questioning him.

It was I thought purely political theater at which Dimon performed very well.

Later I heard Charlie Gasparino speak to the study done by JP Morgan on the health, or lack thereof, of the municipal bond market and the fact that many issuers faced dire fiscal situations.

Once again while this fact is basically known it would be a gross lack of disclosure by the firm as the banker bringing deals for any of these issuers to market if it did not include the report in the bond disclosure documents or official statement.

According to Gasparino the firm's analysis was that the only plausible ways to address the problem would be "raising taxes significantly, slashing budgets, and demanding that public workers pay a portion of their retirement benefits."

This is an excerpt from the article but I would recommend that the full piece be read!

“…people in senior management worried that the study’s stark analysis about the looming threat of unfunded pensions to state and local finances -- and its recommendation on how to fix the problem -- would offend the firm’s municipal bond clients, namely those cities and states that tap J.P. Morgan to underwrite their bonds.

With that, the firm decided that it would keep the study largely under wraps, according to people with direct knowledge of the matter. Only its best hedge fund clients and large institutional investors would receive the report. The cities and states at the heart of the analysis wouldn’t be informed, nor would most public investors.

What's more, J.P. Morgan didn’t include the report’s findings about rising pension costs -- one of the risk factors for any municipal bond -- in the disclosure documents of the state and city bond deals, according to people with direct knowledge of the matter. A review by the FOX Business Network of some these disclosure documents for bond deals underwritten by J.P. Morgan shows that, despite language involving unfunded pensions, the results of the study were not included…”

The full article is at Fox Business here.

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