Blowing up your customers

The Bankruptcy Estate of Terra Securities ASA and the Norwegian municipalities of Bremanger, Hattfjelldal, Hemnes, Kvinesdal, Narvik, Rana and Vik have started an action in New York seeking over $200 million from Citigroup for violations of the United States securities laws. The lawsuit contends that Citigroup misled Terra and the municipalities in 2007 and thereby induced the municipalities into purchasing notes linked to a "tender option bond," or TOB, fund purportedly managed by Citigroup. TOB funds involve leveraged investments in United States municipal bonds. Ultimately, the municipalities lost approximately $90 million to Citigroup, and Terra, a Norwegian securities firm, suffered additional losses when it was forced into bankruptcy.

The lawsuit contends that Citigroup misled Terra and the municipalities in 2007 and thereby induced themunicipalities into purchasing notes linked to a "tender option bond," or TOB, fund purportedly managed by Citigroup. TOB funds involve leveraged investments in United States municipal bonds. Ultimately, the municipalities lost approximately $90 million to Citigroup, and Terra, a Norwegian securities firm, suffered additional losses when it was forced into bankruptcy. According to the lawsuit, Citigroup, through Terra, marketed and sold to the municipalities over $115 million in notes linked to the TOB fund in May and June 2007.

By way of background, a tender option bond fund is a fund that raises money through senior short-term borrowings secured on long-term municipal bonds to fund the purchase of those bonds. It looks like Citigroup sold the Norwegians a bunch of subordinated notes issued by the fund, essentially a leveraged investment in US municipal bonds. US muni bonds typically trade at a yield slightly below treasuries but are tax exempt to US holders which is why the yield is lower than treasuries. Many muni bonds are guaranteed by bond insurers, such as FGIC Corp., Ambac Financial Group and MBIA Inc. and were rated AAA when issued.

The bet is that the fund will earn a profit between the rate they have to pay senior lenders and what they earn on the long-term bond. This might be enhanced if the tax exempt nature of the muni-bonds can be passed through to the senior lenders - tricky but it can be done. TOB funds are little like some of the mortgage backed SIVs except that the underlying credit of the municipal bond issuer will still be investment grade even if the guarantor falls apart, and unlike sub-prime mortgagees the risk of a tax raising municipality defaulting is vey low indeed.

Sounds easy but it isn't. When times were good 40% of all municipal issues were insured by monolines. But now those AAA ratings are imperilled or gone. This has caused the municipal bond market to decouple from the taxable bond market. Whereas historically municipals tend to trade just below Treasury rates, when trouble hit muni yields shot up and bond prices went down.

This means two things for TOBs. First, money market funds are increasingly unwilling to hold the short term senior TOB debt. Second, the TOB fund's hedging stopped working, which meant many TOB funds made losses, which meant withdrawls, which meant funds had to liquidate their positions, selling into a relatively illiquid munical bond market, forcing muni bond prices even lower.

Whatever the rights and wrongs of the case, I have little sympathy for either side.

Have the Norwegians not read Liars Poker? The boys from Salomon took every S&L from Hicksville, NY to Greasy Ridge, OH for a ride and picked their pockets on the way. The difference is that 25 years later, the country boys have come from inside the Arctic Circle.

As for the bankers, what the hell were they playing at? Whatever their case about how they presented the deal, what did they think they were offering? They take a perfectly safe investment instrument (a muni-bond) , wrapped in a guarantee, and instead of selling and trading that, they leveraged it and then sold the junior portion as a long term investment reliant on their ability to manage the liquidity and basis risk they have added to the deal. This wasn't an investment in municipal paper but a bet against Citi's risk management capabilities in return for the no doubt substantial management fees that Citi earned.

If there was ever a case that both sides deserve to lose, this is it.