On November 25 I wrote State of New Jersey Is Insolvent

The state of New Jersey is insolvent. Bankrupt might be a better word. New Jersey is $60 billion in the hole on pension funding and the Governor is planning on skipping payments in a “pension payment holiday” until 2012 so as to not increase property taxes. To top it off, the ongoing plan assumptions are 8.25%. Sorry NJ, that simply is not going to happen. ….

Inquiring minds are now reading that Goldman Draws Ire for Advising Default Swaps Against New Jersey.

Goldman Sachs Group Inc., one of the top five U.S. municipal bond underwriters, is angering politicians and public-finance officials in New Jersey, Wisconsin, California and Florida by recommending that investors purchase credit-default swaps to bet against 11 states’ debt.

Bets against public debt, once unheard of on bonds considered safe enough for retirees, have soared as the National Conference of State Legislatures projects recession-fueled budget crises will cause $97 billion of shortfalls nationwide over the next 18 to 24 months.

It’s “disturbing” to advise investors to bet against the financial health of a state whose bonds Goldman helps sell, Assemblyman Gary S. Schaer, a Democrat who chairs the Financial Institutions and Insurance Committee, said last week in a letter to Chief Executive Officer Lloyd C. Blankfein.

‘A New Reality’

“Shorting municipal bonds — the world is a new place,” said Patrick Born, chief financial officer for the city of Minneapolis. “There’s a new reality, at least for a while.”

The spread on 10-year California swaps widened to 289 basis points yesterday from 93 basis points in mid-September, according to data compiled by Bloomberg. Investors who sold their contracts could have pocketed $196,000. A basis point is equivalent to 0.01 percentage point.

New York-based Morgan Stanley has also recommended using swaps to bet against state credit. While Merrill Lynch recommends the derivatives to “institutions who want a vehicle to express relative value views,” Phil Fischer, a vice president of municipal strategy at the firm, said many are “thinly traded.”

As part of a September presentation to institutional investors on “Best Long and Short Risk Strategies,” Goldman recommended buying credit-default swaps on “a basket of liquid State General Obligation credits with current and worsening fiscal outlooks,” including California, Florida, Nevada, Ohio, Wisconsin and Michigan.

The firm also recommended the derivatives on states with “significant unfunded pension” and other retiree obligations, including Illinois, Connecticut, Hawaii, New Jersey, Massachusetts and Nevada.

The practice of betting against such states is “distasteful,” said Frank Hoadley, Wisconsin’s director of capital finance in Madison.

List of States Affected

New Jersey
California
Florida
Nevada
Ohio
Wisconsin
Michigan
Illinois
Massachusetts
Connecticut
Hawaii

There is probably another dozen or two states waiting in the wings. Expect to see municipal bond yields rise. And states are going to have to cut services, raise taxes, or both. That means more job losses, more foreclosures, and more bankruptcies, all deflationary phenomena.

Mike “Mish” Shedlock
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