Nightmare on Elm Street
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Most of us by now are aware of the financial stresses resulting from the mortgage meltdowns. Large financial institutions such as Merrill Lynch and Citigroup continue to incur large write downs from illiquid securities tied to the mortgage markets. Defaults in mortgage paper is no longer isolated to sub-prime loans, but now has spread over to the prime borrowing. What was once touted as a contained problem limited to $50 billion of paper is now growing into a financial monster that threatens the credit markets around the world.
Like a walk through a house of horrors, more frightening goblins keep appearing around the next corner. The ill investments made in Structured Investment Vehicles are not just limited to the large financial institutions. Enticed by higher yields for short-term money, local governments now seem to have been snared into the easy money trap.
Structured Investment Vehicles wrap a variety of debt from prime to sub-prime into a bundled instrument, which carries a high investment grade rating and a yield higher than money funds; a perfect investment for a municipality or school district whose revenues are collected in lump sums during specific time periods. Major expenses on capital projects may be spread over a long time period. Therefore it would make sense to park funds not needed at the time in a safe interest bearing account. The same idea can be used when a locality borrows large sums of money for future construction projects, thereby offsetting borrowing costs during the construction phase.
But what happens if the funds are invested in SIVs? Though bearing interest payments, these debt instruments, as evidenced by the ongoing troubles of major investment house, have no market. You can get in, but you can’t get out.
This scenario has already played havoc with several local government entities from Montana to Norway. Most notable of late is what happened to an investment pool for Florida government school districts. Back in November the $27 billion fund held $2billion in defaulted paper. The disclosure set off a run on the investment pool that saw its $27 billion dwindle to $14 billion. In order to prevent further erosion and selling of securities, the investment manager froze the remaining assets; a move that left many school districts scrambling to find funds to meet current expenditures. Illiquid Government Investments
Now what would happen if a school district borrowed a large amount of funds for coming construction projects, and then invested those borrowed monies into an investment that yields enough to cover the borrowing cost plus a little extra? No doubt the school district would crow about saving the taxpayers money. But what happens when the district tries to withdraw funds to meet construction costs only to find that such a withdrawal is not possible because the investment was made into an SIV for which no market exists?
It would certainly be a nightmare on Elm Street.
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Mark – thanks for the update on this important issue. You recall we wrote about this about ago in early December in a post “Delinquent Property Taxpayments Cause Problems for Bond Market“.
The New Richmond School District has already borrowed at least $40 million of the $93 million construction project. This project as you remember is the largest school construction project in Wisconsin history by one of the relatively smaller Districts in the state.
I wonder how much of that $40 million is invested through the State’s municipal government fund in SIV’s?
Let’s hope some further investigative work brings this issue into the open and reveals what the status is of this borrowed money.
What would NRSD Superintendt Morrie Veilluex’s minnions say when he has to reveal that the District no longer has access to the borrowed construction funds since the financial vehicle the District placed the money in has become insolvent?
Jack,
I don’t want anyone to construe my post as a story about any of our local government entities. It is not.
But since these problems with SIVs are popping up in the investments made by school districts, city governments, and county governments, it should take no one by surprise if it happened here locally.
Bottom line is that if you are getting an exceptionally high rate of return on short-term money, then chances are that such money funds contain high risk debt.
#1, I’d like to know your source on the already borrowed $40 megabucks by NRSD. State law says that if a large amount of money is requested in a referendum, only small amounts of money can be borrowed as the construction moves ahead. That’s why they scheduled the issuance of bonds as the project moved ahead.
However, with that said, you’re caution makes me nervous Mark. This is just another thing in the mix that could put more pressure on property taxes. Your post was succinct and totally understandable, Mark.