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This, from Bloomberg.com, portends the added risk we have been discussing in the Muni markets. As many have forecast, the muni risk is being too heavily discounted in the equity markets... I will post a another recap of insurers covering the aggregate CDO/RMBS risk and rank them either later on today or tomorrow.

 

Auction Supply `Tsunami' Foreshadows Deeper Municipal Losses

By Michael McDonald

March 3 (Bloomberg) -- U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities.

California, Boston's biggest hospital and Duke Energy Corp. are converting their bonds to other types of tax-exempt debt after auction failures drove rates as high as 20 percent. The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989.

Rates increased last month as investors shunned the securities on concern the insurers that guaranteed the debt may be downgraded, and as dealers refused to buy bonds that went unsold at auctions. The higher borrowing costs are squeezing states and towns just as slowing growth threatens to cut revenue. I know there are some vulture investors hoarding these higher yielding munis, but there is some added risk there.

``It's a supply tsunami,'' said Robert Fuller, principal of Capital Markets Management LLC in Hopewell, New Jersey, a financial adviser to municipalities. ``All of that is going to be redone and it's going to be redone fast,'' he said of auction-rate bonds.

Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Washington-based Center on Budget and Policy Priorities. This is saying a lot...

Jefferson County

Standard & Poor's slashed the ratings on $3.2 billion of debt issued by Jefferson County, Alabama, to below investment grade on Feb. 29, citing costs from auction-rate and other bonds and interest-rate swaps used to finance its sewer system. Junk muni bonds! Who's the insurer???

``The county can provide no assurance that net revenues from the sewer system will be sufficient to permit the county to meet the interest rate and amortization requirements of the liquidity facilities,'' officials said in a notice last week.

For at least a decade, auction-rate bonds allowed municipalities, closed-end funds and student lenders to borrow long term while getting short-term rates with securities whose yields are reset by bids every seven, 28 or 35 days. When there aren't enough buyers, the auction fails and rates are set at a level determined in official statements issued at the initial bond sale. Investors are suddenly left holding securities they may have wanted to sell.

Municipalities sold about $166 billion of the bonds, or half the $330 billion total, according to estimates by Bank of America Corp.

Failure Rate

The market started falling apart last month as banks from Goldman Sachs Group Inc. to Citigroup Inc. permitted thousands of auctions to fail by not buying bonds that went unsold. At least 60 percent of auctions failed to attract enough bidders since Feb. 13, based on Bank of America and Bloomberg data. There were fewer than 50 failures in total from 1984 through 2007, Moody's Investors Service said. This is a very big pop. I think it will portend a historical level of stress in the muni markets. The reasoning that Munis are near default free is a risky assumption.

``We're in a brave new world right now,'' said Ross Berger, head of proprietary municipal credit and a portfolio manager at Wells Fargo Bank in San Francisco.

Yields on top-rated, fixed-rate bonds due in 30 years reached 4.89 percent on Feb. 28, the highest since August 2004, based on data from Municipal Market Advisors. A Bloomberg index of variable-rate demand note yields jumped almost 2 percentage points to 3.17 percent last week.

Market Anomaly

Municipal yields are rising as those on Treasuries fall, creating a market anomaly, since local government debt is exempt from taxes and bonds sold by the federal government isn't. Top- rated, 30-year municipals offered yields last week that were 10 percent higher than Treasuries of comparable maturity, the most in more than 11 years, Citigroup strategist George Friedlander said in a Feb. 29 report.

Hedge fund managers sought to sell as much as $3 billion of municipal securities last week, traders said. ``Bids wanted'' totaled $1.1 billion on Feb. 29, after averaging $600 million the past 90 days, according to a Bloomberg index. This was mentioned in this blog a few days ago.

The auction-market fallout has spread to student loan organizations and corporations. The Pennsylvania Higher Education Assistance Agency, the second-largest seller of auction-rate debt for the past seven years, said it will stop making student loans after paying $24 million in extra interest. Louisiana-Pacific Corp., the Nashville, Tennessee-based lumber company, said last week it will take a charge of about $46 million to $54 million to write down its investments in auction- rate securities.

California Converts

California, the biggest municipal borrower, is exploring ways to replace $1.25 billion of auction-rate bonds after yields on some of the debt almost doubled to 6 percent. States including Wisconsin are also working on plans to convert their high-cost debt, as are agencies such as the New Jersey Economic Development Authority. CA is one of the biggest risks for AGO.

The board of Charlotte, North Carolina-based Duke Energy last week approved plans to replace $883 million in auction-rate securities that its utility subsidiaries sold in the municipal market. Boston's Partners Healthcare System Inc. this week will begin converting $450 million of the debt.

``When you've got many issuers representing hundreds of billions of dollars trying to restructure their bonds all at once, there's obviously a glut,'' said Paul Rosenstiel, California's deputy treasurer. ``It doesn't make for any easy solutions.''