Municipal Bond Market

[lmrhoades]

Henry and others
Is there a big problem with the muni bond market. On cnbc this morning they were talking about it as if it could lose big money. I know bill gross is investing big into the muni bond market and it's done well this year thus far.
Is there a problem that you know of or is it just continued speculation?
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LMR

[lmrhoades]

I've watched the number of failed rate auctions in the municipal bond market grow over the past few days. Although this is outside my expertise, as a trader, any news that might be predictive of the marketplace needs to factor into your thinking. And what I'm thinking now isn't very good.

Over the last two days, auctions for short-term municipal bonds have been finding no buyers. Now, we're talking about the best of AAA-rated organizations, and their debt usually doesn't need much advertisement to find people willing to assume risk on them. We're talking about the Port Authority of New York, for example, or the MTA or various state-run student loan organizations.

Over the last two days, 80% of the auctions on these debt securities have "failed" -- that is, they found no buyers willing to take on the risk of these well-collateralized securities. Interest rates being paid on these bonds have soared from the more common 4% to more than 20%. Municipalities, unwilling to pay such exorbitant interest rates on their debt, have been scrambling to convert their debt to fixed-rate notes and pay off these high-priced securities. The rate curve is about to steepen -- and really fast.

What's interesting about all this, of course, is that's it's simply not supposed to happen.

The municipal bond market is the skinny, pasty, horn-rimmed-glasses-wearing guy in the financial room -- normally crowded out by the ripped-muscled, girl-attracting studs of the equity hedge fund and commodity gunslingers.

But that soft-spoken muni bond guy is supposed to offer you peace, solid returns and most importantly, safety: you're supposed to sleep without a care at night, knowing that your muni bond portfolio is rock-solid and entirely riskless.

At least that's the way it's always gone -- until earlier this week.

Credit market difficulties have found their way into the municipal bond market, as investors are shying away from any security -- even one as rock-solid as municipals -- that are being insured by distressed reinsurers like Ambac Financial Group (ABK) and others.

In situations less dire than this, the investment banks running the auctions have always stepped in as secondary bidders, willing to take on the "risk" of these low-risk securities, holding them on their own books to either enjoy the added interest or peddling them at a profit to clients out of inventory. Starting at Goldman Sachs (GS) , and quickly moving to Citigroup (C) and UBS (UBS) , all of the investment banks have shown an unwillingness to step in with bids for these securities and all have allowed the auctions to simply fail.

Fair-weather friends, we could call them, but all the major banks are feeling the heat of a disaster year from subprime credit writedowns and are unwilling to commit larger amounts of capital to investments that at the very best could only net them a percentage point or two in profit. In this tough world of investment banking returns, that kind of profit doesn't feed the baby.

These auction failures could have far-reaching effects. Surely for the borrowers themselves, who depend on these short term notes to stay alive, there could be issues. Student loans could be withdrawn or become more expensive. Municipalities could look to recoup extra interest costs in higher tolls or other fees.

But that's probably the smallest piece of this puzzle.

Investors in these short-term securities are effectively locked out. One of the major advantages of these securities is their liquidity -- even outside of the reset dates, investors have been able to buy and sell these securities easily, and right now they cannot. They cannot flee into tax-free money market accounts, as these are mostly pegged to the same type of municipal bond positions.

And of course, investor confidence is the biggest issue.

As a trader, the question has to be asked: If you're not "safe" in short-term munis, where should your money be?

While this is mostly a liquidity problem, and not a credit problem because these institutions are all solid AAA, many analysts will not equate the issue with the mortgage mess, even if the roots of it are somewhat connected.

But a liquidity problem is bad enough.

When banks and investors begin to hoard capital, I start thinking. I start thinking about hoarding capital myself. And if I'm thinking about it, I'm sure that others are, too.

These failures of muni auctions amaze me again about the nature and ability to predict the capital markets. Failures like these have never, ever happened before. It's incredible to me how often I'm seeing things that are never supposed to happen.

I'm going to watch this very closely and see how it plays out, but I think the opportunity will come in longer-term bonds, as this scramble to restructure debt will steepen the curve and give opportunity. Of course, I'll need to have more in cash when that happens to take advantage of that. Also, if liquidity becomes the name of the game, that perception could easily spill over into the equity markets.

I'm a trader, and I'm trying to predict what will happen weeks and months from now, not tomorrow.

The subprime problem was well known, analyzed, discussed -- and mostly dismissed -- throughout most of the fall of 2007.

I don't want me -- or you -- to get caught again.
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LMR

[lmrhoades]

On Wednesday, Bloomberg reported that:

Feb. 13 (Bloomberg) -- Bonds sold by U.S. municipal borrowers with rates set through periodic auctions failed to attract enough buyers as banks including Goldman Sachs Group Inc. and Citigroup Inc. that run the bidding won't commit their own capital to the debt.

Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey, with bidding run by Goldman, soared to 20 percent yesterday from 4.3 percent a week ago, according to data compiled by Bloomberg. Presbyterian Healthcare in Albuquerque and New York state's Metropolitan Transportation Authority also experienced failures, officials said.

What began three weeks ago with too few bidders for auction-rate debt backed by relatively small entities, such as Georgetown University and Nevada Power, has widened in recent days to include large issues of state governments, such as New York state's Dormitory Authority. The auction failures provide new indication of Wall Street's unwillingness to commit capital amid $133 billion in credit losses and asset writedowns.

You may recall that I exited my closed-end muni fund positions (Nuveen Dividend Advantage Municipal Fund 2 (NXZ), in particular) the day after Martin Luther King day. Well, NXZ been trending up ever since, and I had a great deal of self-doubt. Yesterday, it gave back 3.86% which was an enormous move for a bond fund. It's still above where I sold it, but I'm beginning to think that my conservatism may be vindicated.

Despite Warren Buffet's offer to provide a back-stop to the monoline insurers, the credit crisis is far from over. First of all, it's clear that if the monolines give up their muni business they may as well sign their own death warrants. The way I see it, the muni business is the only bargaining chip they have, as in "If we go down, we take the system down with us. So how about a few billions to help us out?"

That said, I'm sure that eventually, most of the muni bonds will find a high quality insurer. Their yields are very attractive now, and would be even more so should the dividend rate cut expire in 2010. The way things are going, soon, I may even have a chance to go back in for le
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LMR