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Why is Illinois Using Credit Default Swaps?

Dennis Byrne 3 September 2010 3 Comments

You remember credit default swaps, right, the financial “instrument” that pricked the housing and economic bubble?

Illinois is “enjoying” the same kind of debt bubble that led the nation into its current financial mess. I call it a debt bubble because if all the borrowing that the state does to keep it afloat ever becomes no longer possible, if Illinois defaults on the bonds it has sold to millions of investors, Illinois is finished. Kaput.

It might surprise you that under girding Illinois’ massive debt are credit default swaps (CDS), the same financial instrument that had turned a prosperous national economy into hash. In short, the state’s borrowing of hundreds of millions of dollars is getting a lot more expensive, and the chances of an Illinois debt bubble bursting increasing.

CDS are the same kind of insurance that AIG sold to guarantee that the mortgage backed investments wouldn’t fail. The only thing it guaranteed was utter chaos when homeowners and buyers (investors) lost confidence in the value of housing. (For more on how that happened, go here.)

CDS are a form of insurance that works like this:

Suppose Illinois is selling $100 million worth of bonds to investors to help close the state’s budget deficit. As an investor, especially in a state whose finances are shaky, I tell the state that I want a guarantee that if it ever defaults, I still want my money. The state responds, “Okay, we’ll sell you some insurance (CDS) that will guarantee that you’ll get your money if we ever default.” The state is willing to do this because it gets some extra fees from me and because it believes that it will never default.

Good luck.
You’ll remember that when housing prices plunged and the value of those investments likewise plunged, the investors started to collect–or at least try to collect–the CDS to cover their losses. Sorry, they were told, the well is dry; too many people dipping into it all at once.

Likewise, Illinois has sold CDS to investors who have purchased the state’s bonds. But as the state’s financial condition has worsened, the cost of that insurance has risen (because buying state bonds is considered to be more and more risky).

What will happen if those bonds become so risky that few people are interested in buying them? Or the cost of CDS becomes so high that investors refuse to pay the premiums and, thus, won’t buy the bonds? Or when Illinois can no longer afford to buy back the bonds or pay the interest on them? How will we finance state services? How high will taxes have to be raised? What services will have to be cut?

I’m trying my best as a non-professional financial observer to understand how this works because Gov. Pat Quinn, House Speaker Michael Madigan and the rest of the Democratic financial thugs who run Illinois are increasingly depending on borrowing (selling bonds) to continue funding state programs.

I’ve tried to put together a package of links that might help explain why this is inviting a disaster. I must warn you that this isn’t easy reading, and I won’t claim to fully understand them. I’ve read enough, though, to scare the bejabbers out of me.

First, here is an analysis that shows that “Illinois has the highest default risk of all states.” Even greater than California—the state widely regarded to be in the worst financial shape—and Michigan—a state that has been devastated by the bankruptcies of two auto companies.

Then, here is analysis that asks: “Is Illinois Worse Off Than Greece?” It notes that “Illinois Municipal Debt Defies Gravity” and that “The state is in its worst cash position in its 200 year history.” Take special note of Chicago’s financial problems and this: “Hey, Mr. and Mrs. Illinois Teacher, Reggie Middleton thinks your pension fund is picking up pennies in front of a freight train!” It focuses on how the pension fund has been engaging in risky investments. And this should shock you: “The pension fund usually reinvests the sum of the proceeds from the bond sale into financial markets to try and beat the 3.84% interest rate, however, in 2009, the TRS fund lost 22%, even as the S&P 500 strengthened by 26%.”

Some more:

Illinois Borrowing $900 Million as Credit-Default Cost Doubles.

Illinois `Poster Child’ of Debt Crisis Draining State Services, Group Says..

Democrats must figure that they can avoid a state financial implosion by waiting until after the November elections when they intend to pass a massive tax increase. The thinking would be that it would be enough to restore confidence among investors in Illinois’ bonds, thereby keeping the borrowing going. And everything will be hunky dory.

There are a few things wrong with such a scenario, not the least the possibility of Sen. Bill Brady, the Republican gubernatorial candidate, knocking off incumbent Democrat Pat. Quinn. There’s also the possibility that even if Quinn and the Democrats retain their firm grip on the state, that they have started a process that will inexorably lead to financial collapse.
Then what?

**

Dennis Byrne is a regular columnist for the Chicago Daily Observer

image Col Wilheim Klink preparing to say “Vat is this man doing here”

3 Comments »

  • Stephen Jordan said:

    I understand the article’s finance, but I don’t understand why Alexi Giannoulias has the temerity to run for any elective office after: 1, Helping drive Broadway Bank to ruin and leaving the bill to us while he and his family walked off with over $150 million; 2, Managing Bright Start and not firing Oppenheimer Funds; 3, Serving as the Illinois State Treasurer for the past four years without pulling the fire alarm as the state’s finances went down the tubes. Perhaps he was too busy coming up with the idea of using credit default swaps to sell essentially worthless bonds.

    While I’ve never understood insurance company financial statements, I do know that credit default swaps are only as good as the company writing the insurance. A prudent investor might keep that in mind considering the recent fortunes of AIG and Municipal Bond Insurance Association (MBIA), the subject of an excellent new book, “Confidence Game,” by Christine Richard.

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  • Gerald Pechenuk said:

    Dennis,
    Obama MUST RESIGN NOW, so that we can get the Glass-Steagall bill re-enacted NOW!!!
    This, is part of what FDR put in the first 100 Days of His Administration in 1933, with bi-partisan support. It separates commercical legitimate banking from speculative, insane banking, that type which our Obama-loving Democratic Candidate for Senator, just loved to give out when he was making decisions at his late and unlamented, Broadway Bank. He actually gave a lady a million dollar loan open up an account to speculate on foreign exchange markets!!!!
    I think Alexi needs to go back to first grade and start his education all over.
    Also, his good friend and pick-up basketball buddy President Obama needs to be right there with him. He has proposed, in words, a $50 Billion Dollar Program for infrastructure, BUT THERE IS NO BILL FOR THE CONGRESS TO DO IT!!!!
    Obama Should Resign NOW! Reports are that Obama is cracking up and close to a breakdown. As they say, in the schoolyard, WE NEED A DO-OVER!!! Obama has fouled out!!!! NO MORE CREDIT DERIVATIVE SWAPS AND OTHER FUNNY MONEY GAMES ALLOWED!!!

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