What is this place?

The stock market is getting crushed today, but that hardly tells the story. The Dow falling 350 points is rare, but its happened many times. What's happening right now in the credit markets is unprecedented.


I'd like to focus on an under-reported corner of the credit markets: municipals. We have a variety of factors converging to cause municipal bonds to perform extremely poorly.


First of all, market makers are hoarding cash. Remember that the Wall Street titans were never dominant municipal players. The better muni shops among big Wall Street firms were the ones with large retail operations, like Merrill Lynch. Regional brokerages were always major players (as a group) because they had the local customers who wanted to buy local bonds. A firm like Morgan Keegan or Stephens knew the market in Mississippi or Arkansas or Tennessee better than anyone from New York.


Regional brokers face a more uncertain funding than larger Wall Street firms, especially if they are not tied to a bank. Typically dealers fund their inventory either through repo or through bank credit lines, with the later probably more common among regionals. The bank credit lines function very much like repo in that there is usually some basket of acceptable collateral and that the line must be over collateralized by some amount.

The reality is that those bank credit lines are usually not contractually committed for an extended period. In other words, the lending bank usually has the right to pull or reduce the line at any time, or at least with relatively short notice.

In that kind of environment, dealer firms cannot hold inventory. If they were to see their credit lines taken away, or even reduced, the firms would see significant odds of sudden bankruptcy. Forced sale of anything right now, even municipals and government agencies, would entail significant losses.

So municipal trading must occur with no market makers whatsoever. Obviously that makes the cost of immediate liquidity much higher.

Add to that the fact that municipal funds, particularly money market funds, are seeing large outflows. Currently tax-exempt money market fund balances are about 10% below August levels. While there have been some inflows the last couple days, there is still tepid demand for money market securities. And investors are not being unreasonable in selling their tax-exempt money market funds. Most muni money market securities rely on bank letters-of-credit for liquidity. And various U.S. regional and European banks are major muni LOC providers. In fact, Wachovia was a very big player in that market. While Wachovia-backed bonds are to be backed by Wells Fargo or Citigroup, certainly there is good reason to be worried about other banks.

Meanwhile other municipal buyers are pulling back as well. While I have not seen stats on long-term muni funds for September yet, anecdotal evidence is that there have been outflows. Plus there is the spectre of closed-end funds deleveraging. Closed-end funds have been using auction-rate securities to create leverage for many years, but have recently been trying to refinance those securities. The current market has made that all but impossible. So there is a good chance that closed-end funds will have to sell a percentage of their current holdings to deleverage.

On top of everything, things aren't exactly rosy for municipal governments. There is no doubt that states and local governments are going to face their most difficult budget periods in a generation, and it might not get much better next year either.

Still, I think intermediate-term munis are a relatively good trade. You've got pre-refunded bonds, which are backed by Treasuries, trading at a higher yield than Treasuries. You've also got hospitals, public universities, transportation authorities, etc., that are less sensitive to housing prices and general economic activity. I think if you focus in that area, and can stomach the lack of liquidity, those will turn out to be good long-term trades.

In terms of muni weekly and daily reset VRDNs, if you are going to play in those, make sure you have a ultra-safe LOC provider. There are bonds out there with Fannie Mae and Freddie Mac LOCs which would seem the strongest. But again, be sure you understand exactly what the LOC means. If you can't understand it, don't buy it.