Sense on Cents

Those strapped for cash will go to great lengths to buy time and seek relief. This reality is not pleasant but it is reality. In a world awash in a sea of debt, the debtors will continually be faced with the prospects of devaluing, defaulting, or restructuring their debts. Prior to defaulting or restructuring, debtors will often resort to “unique strategies” to postpone the day of reckoning.

This reality very often plays out at the individual level or the small business level. When large corporate entities are forced to “unique strategies” to continue operations, that typically is not a very good sign. But what about municipalities? What does it mean when a city, state, or town is forced to a “unique strategy” in order to continue operations? Not a very good sign either, right? Right.

Well, indications are that the state of Illinois is resorting  to a “unique strategy” and “paying up” in order to get short term financing.

Let’s navigate as these developments are highlighted in the weekend Wall Street Journal, Illinois Seeks Wall Street Cash,

Times have gotten so tough for the Illinois state government that it has begun turning to Wall Street trading houses and hedge funds to help pay its bills.

The state owes more than $4.5 billion to vendors large and small, ranging from prison-cleaning crews to schools for the disabled. Tax shortfalls and pension obligations continue to leave the state light on cash.

Quietly, the state has begun reaching out to Wall Street and other investors with a novel plan to plug this shortfall. Instead of further tapping the public debt markets, Illinois is trying to tap private sources for short-term cash to repay vendors.

Hmmmm….what comes to your mind when thinking of “private sources for short term cash to repay vendors”?

Are you thinking about a guy down at the corner who might walk around with a wad of cash while saying he is involved in ‘venture capital’?

Your Dad might say, “Oh, that fella, he’s a loan shark.”

Let’s continue.

Such efforts reflect the pressure many U.S. states face and raise questions about the lengths some governments should go to in funding their operations. And they put Illinois, which has endured budget strains for a decade, in the uncomfortable position of pitching its fiscal problems as someone else’s profit opportunity.

The Illinois approach works like this: Investors take over the delinquent bills owed by the state to its vendors. Those vendors are due a 1% penalty each month after the state falls behind by 60 days. The financial investors make the vendors whole and are entitled to 1% monthly penalties until the state pays the investors back.

With Illinois currently five months behind on its bills, investors who participate in the program today could collect 3%, which state officials say works out to an about 12% annualized return. The rate is double that of many long-term Illinois state bonds, which pay roughly 6% annually.

Wow, very interesting!! A 12% annualized return for what is described as a short term loan. The WSJ comparison to long term Illinois paper is actually an improper comparison. Why doesn’t the WSJ compare this to 1-yr Illinois paper? Perhaps the comparison there would be too stark and may actually unnerve investors who hold that 1-yr paper.

How much is Illinois looking to borrow?

Illinois plans to roll out the program to thousands of vendors in the next several weeks, which could help pay off as much as $2.5 billion.

Why would Illinois be willing to pay a 12% annualized return to investors? Is this a great deal? Can retail investors get involved?

In my opinion, the state of Illinois and its investment bankers must believe that the state would not be able to raise sufficient funding in the market to meet these bills. As such, the state is forced to ‘pay up’ to attract capital.

Is this a great deal? Can retail investors get involved?

I would be less focused on the relative merits of this deal and the fact that this deal will likely not be offered to retail investors and much more focused on WHY the state is resorting to these measures. When a state is paying 12% to attract new money, what does that mean for the value of its outstanding obligations?

They may not be worth what you thought.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

This entry was posted on Monday, December 13th, 2010 at 7:10 AM and is filed under General, municipal finance. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.