Are Bankers Conspiring to Raise Your Taxes?

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Are bankers conspiring to raise your taxes? Even if that's not their primary motive, a lot of people think that's just what will happen.

In recent weeks, California has demanded information from each of JPMorgan Chase (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and Barclays (NYSE: BCS  ) . California's concern: Great numbers of credit default swaps are appearing in tandem with the bonds these bankers have underwritten for the state -- and to California's way of thinking, it looks an awful lot like the bankers may be betting against their own client.

Shades of Goldman Sachs and the mortgage derivatives fiasco, you say? It sure looks like it. And this particular dispute involves more than just a few mortgage bulls getting gored by a couple of hedge funds. From California to Massachusetts, from Michigan to Florida, across the nation, states are screaming foul.

Foul ball
It works like this: When a state issues a bond, it must pay interest to the bond buyer. And generally speaking, the stronger the state's financial position, the lower the interest rate it must pay -- because the buyer has less fear the state will default.

But there's another way to reduce buyer risk. Given a particularly "iffy" bond to sell, a bank might offer to sell insurance against the default risk in the form of a credit default swap, or CDS. That's fine as far as it goes -- but according to the states, there seem to be an awful lot of these CDSes floating about, and they're beginning to suspect that the bankers are selling CDSes to people other than the buyers of their bonds.

Who, exactly? Short-sellers. Hedge funds. People who stand to make a profit if the state goes bankrupt. As George Soros explains: "Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential … [which] encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds."

When that happens, California and all the other states, along with local governments like New York City and the Port Authority to boot, could face a real dilemma. As bond prices fall, they must offer to pay higher interest rates on new bonds they issue in order to attract buyers. That, in turn, makes it harder for them to maintain their debt, increasing the chance that they'll default.

Sound like a vicious circle to you? It does to me. But there's still a solution to it, and we find a clue to this solution in how these CDSes are labeled: "Naked CDSes."

"Naked? Where did I hear that before?"
You're thinking of the "naked shorting" debate of a few years back. The one in which (Nasdaq: OSTK  ) CEO Patrick Byrne led a crusade against the "Sith Lords" shorting his company's stock.

For years, Byrne railed against the forces of darkness that were dogging his company, predicting its imminent bankruptcy, and betting against its survival by shorting the stock. Yet somehow, despite all the opposition, Overstock recently hit a 52-week high, and has nearly tripled from its March 2009 lows.

How did Overstock do it?

Nudism is a fad ...
Not by suing the shorts into submission, apparently. Byrne never did totally shake the shorts. In fact, to this day, 17% of the company's float is still sold short.

Rather, Overstock put a leash on its spending (on selling, general, and administrative expenses), grew its revenues, and after years of posting nothing but losses, finally turned a profit last year. It increased collections, and pulled its accounts receivable number down to earth. Overstock built up its cash reserves, and began paying down its debt.

In short, Overstock put its financial house in order. And as it has done that, proving itself viable as a going concern, the short case has become less attractive. The crisis passed, and the stock began to rise.

... but don't be a Nuddite
It seems to me that America's states and municipalities can find a lesson in Overstock's revival. The way to silence critics is not by gagging them. Not by suing. Not by whining about how unfair the world is being to you. It's by changing the situation.

Cut spending. Defuse the exploding time bomb of unfunded public pensions. Quit loading up on bond debt, appeasing the voters of today by loading down their children with mountains of debt. And yes, if necessary, raise taxes. Make the taxpayers feel what runaway entitlement spending means to them.

In short, put your financial houses in order, and make it unprofitable for the bankers to short your state.

It worked for Overstock. It can work for America.

Or if you've got a better solution, tell us about it in the comments section below.

Fool contributor Rich Smith has no position in any stocks named above. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 28, 2010, at 3:17 PM, militauro wrote:

    I was going to recommend this article until I saw raise taxes. I, for one, am sick of taxes. Spending is out of control and I think there is a lot of work to do in that department before even thinking of raising taxes.

  • Report this Comment On April 28, 2010, at 8:46 PM, ChrisBern wrote:

    Brilliant article, although like TyrantBone I didn't see the point of adding in the "raise taxes" line towards the end when you had previously established how states' financial houses are in such disorder--it's immoral to raise taxes when there are such easy efficiency gains available through standard belt-tightening.

    But back to the point, overall the article is excellent. If states simply managed their budgets responsibly, it would be a poor investment decision for someone to try and profit by shorting the state's debt. As it is, it's an interesting investment because everyone knows there are several U.S. states which are mini-Greeces waiting to blow.

  • Report this Comment On April 28, 2010, at 10:16 PM, rd80 wrote:

    "Shades of Goldman Sachs.."

    Actually, it's exactly the opposite of Goldman's alleged fraud. Goldman is being charged with failing to disclose the risks of securities it sold. In this case the bankers are specifically pointing out the default risks of bonds from over leveraged issuers.

    Good article. Naked CDS should be restricted like naked short selling. Then the SEC should enforce both.

  • Report this Comment On April 29, 2010, at 1:00 PM, rhutmacher wrote:

    Great suggestions. I like that you show that investors being wary about a state's financial situation is the state's fault, not the investors. I do agree with the first two comments though, when there is so much wasteful spending that can be cut from state governments (California in particular) then tax increases should be the last options. Congrats to Byrne for making the right choices to keep his company afloat!

  • Report this Comment On April 29, 2010, at 5:12 PM, TMFDitty wrote:

    @all: Yeah, I figured the "raise taxes" option wouldn't go over well. But seriously -- how else do you convince voters to countenance spending cuts?

    My view: You've got to hit 'em in the wallet first, make 'em feel how much they're vicariously spending.


  • Report this Comment On June 10, 2010, at 11:02 PM, dockofthebay wrote:

    Why would the banks sell the CDSes if they thought that the states were likely to default? The banks would then be responsible for paying off the holders of the CDSes.

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