Could Credit Default Swaps Undermine the Fiscal Stability of Municipal Bonds?
For years, the municipal bond market was the securities markets’ dowager queen — regal in its slow and steady processes and super solid in its credits. The debt was a product of a growing U.S. economy that needed and could afford the improvements the bonds financed. The bonds seldom had repayment problems. But times changed. In the last couple of decades, the municipal bond market lost its innocence as waves of financial innovation swept over it. Investors and issuers could speculate on future interest rates as embedded in the variable-rate bond and interest-rate swaps. More recently, credit default swaps (CDS) let investors bet on perceptions of issuers’ ability to meet their obligations. The CDS has a somewhat notorious past. These private contracts bet on the likelihood of default by a borrower. When default likelihood increases, the contract value to pay off in case of default increases. Unlike bond insurance, however, one need not own the defaulting bonds to collect. Rather, an i
