Son of Subprime, Part II

Here’s a myth we’d like to smash. It’s the one about how America stopped being a manufacturing economy and became a “service” economy.

The truth is found in figures like these:

  • In the late 1960s, the finance sector accounted for around 20% of corporate profits. Just before the onset of the financial crisis, it was 40%.
  • Financial stocks made up 13% of the S&P 500 in 1999. Just before the onset of the financial crisis, it was 22%.

Call it the “financialization” of the economy.

The root of the problem is the nature of investing itself – at least, the public form of investing, as practiced by most investors and as tempted by Wall Street. The idea of it is that a man can get rich without actually working or coming up with an insight or an invention by careful study or dumb luck. All he has to do is put his money “in the market” by handing it over to Wall Street, and poof! – by some magic never fully described it comes back to him tenfold.

Too often in the last couple of years, it’s felt as if Wall Street’s hocus-pocus has had the opposite result – collapsing wealth tenfold. We see it happening all over – in sovereign debt, municipal debt, even the gold market.

In yesterday’s edition of The Daily Reckoning, I explained why municipal bonds, in general are a bad bet. The numbers just don’t add up. Municipal finances have become as ugly – and as unsustainable – as the federal government’s. Municipal obligations are simply too large, relative to current and (likely) future revenues. It is a classic “train wreck.”

All this being said, betting against municipal bonds, or funds of muni bonds, is a bad idea for most investors.

Most of the closed-end funds and ETFs that hold municipal bonds pay monthly or quarterly dividends. Which means that a short seller of those securities would have to cover them while they wait for their bet to pan out. And the muni breakdown could be months away, if not years.

Also, when muni funds do suffer, the fallout may not be as dramatic as the housing bust.

Even if you manage to pick the right municipal bond to short, it’s tough to make money. Take an ETF of Californian muni bonds (CMF). You’d think it would have suffered terribly over the last few years. But it never fell more than 20% during the worst of the credit crisis.

Furthermore, financially stressed municipalities pull all kinds of strings to avoid actually defaulting. It’s an all-too-common practice for cities and states to rescue failing projects (with taxpayer money) to prevent the repercussions of a bond default.

Those wishing to bet against muni bonds – the fates of local and state balance sheets – are better served shorting companies that hold a large portfolio of municipal bonds or those that are in the business of insuring munis. The latter category means the monolines like MBIA, AMBAC and Financial Guaranty.

As for the former, organizations with large portfolios of municipal bonds, one in particular comes to mind. It has a notoriously opaque business and balance sheet. It’s a bailed out, flailing company that also holds the world’s second largest portfolio of American municipal bonds…


“AIG holds approximately $48.6 billion of tax-exempt and taxable securities issued by a wide number of municipal authorities across the US and its territories,” its latest 10-K boasts. “The average credit quality of these issuers is A+.” It continues…

Currently, several states, local governments and other issuers are facing pressures on their budget revenues from the effects of the recession and have had to cut spending and draw on reserve funds. Consequently, several municipal issuers in AIG’s portfolios have been downgraded one or more notches by the rating agencies.

The most notable of these issuers is the State of California, of which AIG holds approximately $1.1 billion of general obligation bonds and which at Dec. 31, 2009, was also the largest single issuer in AIG’s municipal finance portfolio. Nevertheless, despite the budget pressures facing the sector, AIG does not expect any significant defaults in portfolio holdings of municipal issuers.

In our opinion, these two paragraphs alone warrant intense suspicion. AIG holds tens of billions in munis, and with an average rating of A+, a lot of them aren’t very good. The company’s stake is so big that the fate of muni bonds and AIG is intertwined.

In a company presentation to the Treasury Department, AIG warned, “A forced sale of AIGCI’s investment portfolio would significantly stress the US municipal bond market.” In short, if munis fall, so does AIG… and vice versa. Gravity, it seems, is tugging at both.

“AIG has no common shareholder equity remaining on its balance sheet,” famous short seller Steve Eisman proclaimed at Grant’s 2010 spring investment conference. “It would likely be insolvent if not for government support.”

Eisman, subject of Michael Lewis’ book The Big Short, publicly announced his shorting campaign against AIG in early April. He’s famous for nailing the subprime bust, netting his hedge fund clients ungodly amounts of money. Eisman is also often cited as mentor to Meredith Whitney, the analyst who so spectacularly called out bank stocks in 2008.

Eisman has built an argument against AIG almost as complicated and difficult to comprehend as AIG itself. We’d boil it down to this:

  • AIG, by Eisman’s estimation, carries over $124 billion in debt, even taking into consideration the possible sale proceeds of its best units.
  • The business itself, says Eisman, is worth $88 billion.
  • The government owns 79.9% of AIG, which it hopes to sell as soon as possible.
  • Shares of AIG have soared in the last year, from $6.60 in March 2009 to just under $40 today.

Factor in a $48 billion portfolio of muni bonds we think are suspect (at best) and you’ve got a fine case for shorting AIG.

Of course, betting against AIG is not a sure thing. The principal risk is the government. It has saved AIG from bankruptcy once. There’s no guarantee it won’t do it again. The Treasury could lend more money or forgive AIG’s debt. The Fed could give greater access to lending facilities. We feel, however, that the public ire toward both AIG and taxpayer bailouts is so strong the government will offer AIG more support only under extreme circumstances.

So with the caveat that this is only for the adventurous, you might consider short-selling AIG, say, above $40 a share. Fair warning: It’s a “crowded short.” Your broker may have trouble locating shares to borrow. But Dan Amoss of Strategic Short Report agrees with Steve Eisman’s scenario: The government will convert its preferred shares to common stock – massively diluting existing shareholders and driving down the share price. Still, don’t expect this to occur until after the midterm elections in November.

Even if you don’t short, AIG, beware munis!

Addison Wiggin and Ian Mathias
for The Daily Reckoning

The Daily Reckoning