Municipals and Chrysler: What happens to one will affect the other

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt...

Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County.

And NOW young monoline... you will die

Moody's has downgraded FSA and Assured Guaranty on Friday, claiming that with the future of municipal monoline insurance uncertain, it is unlikely that any stand-alone insurer could ever get a Aaa rating. I predicted the death of these insurers back in July when Moody's first put both on negative watch. For several months it appeared I was wrong, as either FSA or Assured wrapped approximately 22% of all new municipal issuance from August 1 to today. Assured's stock price rose from $11 to $17. They worked out a deal to re-insure CIFG's muni book. They agreed to purchase FSA. All in all it seemed like there were plenty of believers in municipal insurance.

But Moody's was the only doubter that mattered. Now municipal bond insurance is all but extinct.

Now I've outlined a good case for why municipal insurance should continue to live on. But forget about that. One can also make a case that FSA and/or Assured Guaranty shouldn't get a Aaa rating because of issues related to those companies specifically. But that's not what I want to talk about either.

What bothers me is Moody's assertion that demand for municipal bond insurance might decline and therefore no firm can get a Aaa rating.

Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations.

And by the way, why the hell has AGO's stock price risen since this news? They are toast, and I'm short.

Big day for the monolines

Wednesday was a big day for municipal bond insurers Ambac and FSA. Muni investors may be seeing some light at the end of the monoline tunnel. Stock investors in Ambac should be careful.

FSA announced a net loss of $330 million in the second quarter after increasing its estimated claims on residential transactions by $603 million. But the bigger news was that parent Dexia has contributed $300 million in fresh capital to FSA, and in addition has assumed all risk in FSA's guaranteed investment contracts (GICs). In response, S&P affirmed FSA's AAA rating, although the outlook was revised to negative. Fitch affirmed FSA's rating at AAA with a stable outlook.

There is no word yet from Moody's, who had put FSA's Aaa rating on negative watch in July. However, Moody's did release a very telling FAQ on their ratings methodology for the monoline insurers. Moody's claims that their ratings methodology has not changed, but a simple read of ratings reports from late 2007 indicated a focus on excess capital beyond "stress case" losses. In putting FSA on negative watch in July, Moody's emphasis has clearly shifted to financial flexibility. One might conclude that Moody's now views losses on structured finance products as too uncertain to estimate, and therefore has shifted their focus on an insurer's ability to raise new capital no matter the loss level. Nothing in the Moody's FAQ says this in so many words, but there are statements that hint at this sort of thinking: "Moody's believes that both FSA and Assured [Guaranty] will be able to meet claim payments with a very high degree of reliability. However, the compositions of their insured portfolios... may leave them vulnerable to a higher degree of volatility than their existing business models can sustain at the current Aaa ratings."

Meanwhile, Ambac reported first quarter profit of $823 million. Unfortunately, that figure reflects a $976 million gain due to deterioration in Ambac's own CDS spread. Its a frustrating quirk of the mark-to-market accounting rules and it really renders Ambac's as reported income statement irrelevant. But the rationale is quite simple. If a CDS contract with Ambac as the counter-party were traded on the open market, there would certainly be a discount for Ambac's credit worthiness. Since Ambac is effectively short all these CDS contracts, if the value goes down for any reason that's a gain for Ambac! Worth mentioning that Ambac's CDS have improved significantly since June 30, (quoted at 18 points up front, down from 36). On the conference call Ambac indicated that the $976 million gain would have swung to a $1.3 billion loss had they used 7/31 CDS figures.

Media reports are going to focus on the CDS loss/gain shell game, but that's is all besides the point. What really matters to Ambac investors is:

• Clairty on their expected losses in structured finance
• Efforts to terminate CDS contracts, thus lending clarity to the their expected losses
• Progress on recapitalizing Connie Lee

On that front, Ambac reported mostly good news. Real clarity on structured finance losses isn't coming any time soon. The housing and economic picture is just too uncertain. But Ambac is now all but fully reserved on their remaining CDO squared transactions with large RMBS exposure. Therefore any recovery in these assets will be accretive to capital.

Ambac management suggested that they remained in serious talks to commute additional CDS contracts. Ambac had announced a deal with Citigroup on August 1 to terminate $1.3 billion of protection on a CDO-squared transaction in exchange for a cash payment from Ambac. When asked why Citigroup (or anyone else) would agree to terminate if Ambac is indeed a strong counter-party, company management suggested that some of their counter-parties may have bought CDS protection on Ambac and now have a large gain on that hedge. The way it was said leads one to wonder if Ambac in fact knew this to be the case. Either way, the company was positive on the prospects of future termination deals.

In addition, Ambac has been working to eliminate or reduce RMBS exposure by searching for violations of representations and warranties in their insured transactions. Finding such violations would allow Ambac to void some or all of an insurance policy. During the quarter, Ambac recorded $339 million in reduced loss reserves related to such violations. The company indicated that a survey of some of their higher delinquency transactions showed a 80%+ "hit rate" on representation and warranty violations.

Finally, Ambac indicated that progress on capitalizing Connie Lee, a dormant insurance subsidiary, is on schedule. The plan is for Connie Lee to capitalized with $1 billion in cash, be insulated from Ambac's existing insurance exposures, and therefore get a stable AAA rating. In theory Connie Lee could then begin municipal insurance underwriting. Ambac indicated they had completed the "second step" of what would be a 3-4 step process. Ambac believed Connie Lee can be up and running by October 1.

All this is making Ambac more likely to remain solvent, especially if more progress can be made on terminating CDS on structured finance. But the idea that Connie Lee can become a force in the municipal insurance business is still a long shot. And absent that, there is limited profit potential for Ambac. The most likely scenario seems to be that the company survives the next couple years and then eventually sells their remaining portfolio to some third party. That would likely leave some non-zero amount left over for common shareholders, but not much. So you really have to wonder about Ambac's meteoric rise over the last two weeks: from a low of $1.74 on July 28 to $5.85 today.

But any outcome where Ambac remains solvent is good for municipal investors. If Ambac can stabilize at any investment-grade credit rating, Ambac insured municipals will appreciate quite a bit.

Ambac: Perhaps she could still be of some use to us

Hot on the heals of Security Capital's agreement with Merrill Lynch to unwind 8 credit-default swaps (CDS), Ambac and Citigroup have reached a similar agreement. The arrangement has Ambac paying Citigroup $850 million to terminate approximately $1.4 billion of a CDS referencing an so-called CDO-squared transaction.

Collateralized Debt Obligations (CDO) with asset-backed securities (ABS) as collateral, a category which includes CDO-squareds, are the primary problem facing monoline insurers. While the monolines face losses beyond their initial expectations on a variety of structured finance transactions, monolines senior position in these transactions are limiting actual losses. ABS CDOs were creating using mezzanine ABS securities, many of which are already suffering massive losses.

These agreements to terminate CDS are a major positive for the monoline insurers, at least in terms of solvency. It turns an unknown into a known. Ambac's loss on the CDS in question was an unknown. Some even believed Ambac would take a total loss on the transaction. Now their loss position is known: $850 million. That's the end of it.

Beyond that is the fact that Ambac had actually written the position down by $1 billion. So the company will be booking a $150 million gain. This proves, with an actual trade, that in at least one case Ambac was being conservative in its valuation of liabilities. While not proving anything per se, its fair to interpret this as a significant positive in terms of Ambac's future mark-to-market losses.

Finanally, this should improve the capital situation at Ambac Assurance. Not only will the company record a $150 million gain, but it has eliminated a significant source of loss uncertainty.

This is all great news for municipal bond holders. If Ambac and other monolines can stabilize, even at non-AAA ratings, the market will once again see municipal insurance as having some positive value. Currently bonds insured by any of the downgraded insurers are trading as though the insurance has negative value. So any sort of stabilization would probably cause these bonds to appreciate in value.

However, I'm weary of the run-up in Ambac's stock price. The day of the announcement the stock had risen over 60% at one point, and closed Monday even higher. In order for common shareholders to get value out of Ambac, the company will have to resume writing policies. While they might be able to do reinsurance with a AA rating, the opportunities will be limited.

Could Ambac regain a AAA rating? Consider Moody's rationale for putting FSA and Assured Guaranty on negative watch, namely uncertainty surrounding the future of monoline insurance in general. So even if Ambac, or other insurers, could significantly improve their capital situation, unless it is clear to the ratings agencies that Ambac's franchise is in tact and they can resume writing new policies, they will not regain a top credit rating.

And 15 once we reach Alderaan...

Today Ambac is out with news that they too have reached an agreement to terminate a CDS contract with Citigroup. The CDS had $1.4 billion notional and was settled for a payment of $850 million. On Monday, Security Capital reached a similar agreement with Merrill Lynch on 8 CDS, canceling $3.7 billion in CDS for a payment of $500 million.

Remember that a CDS is nothing more than an exchange of risk. One party agrees to pay a periodic fee, while the other party agrees to make up any lost cash flow on a referenced security.
So let's say you enter into a plain vanilla CDS contract referencing Kraft. Let's say its $10 million notional and the deal spread is 76bps (about what Kraft is right now.) Now let's say that the spread on Kraft CDS widens to 100bps. Your contract at 76bps has some positive cash value (about $110,000 on $10 million notional), because of the movement in spreads.

Why? Because you currently own protection on Kraft and only have to pay $19,000/quarter for that protection (76bps * 10 million / 4). Anyone who wants to buy protection now has to pay $25,000/quarter (100bps *10 million /4). Through the magic of Bloomberg, we can calculate what your contract is worth: about $110,000. This means that someone would be willing to pay up front $110,000 to "buy" your lower protection payments.

Now let's say Ambac was the counter-party on your Kraft CDS, and Ambac wants out of the trade. Maybe you are happy to monetize your profits so when they offer you $110,000 you agree.

The media headlines would say that Ambac had exited their $10 million in Kraft risk in exchange for a payment of $110,000.

Now let's look at the deal cut by SCA and Merrill Lynch. Since CDS on the ABS CDOs in question don't trade regularly, we can't tell what the "fair value" actually is. Safe to say that the deal between SCA and Merrill was in part a distressed exchange. If we look at the AAA tranches of the ABX index, the prices range from $88 to $44. It is my contention that ABS CDOs, even if they include large non-RMBS exposure, can't possibly be worth more than the ABX, assuming we're controlling for vintage.

We know that SCA paid Merrill approximately 13.5% of the CDS notional value. That'd imply a dollar price on the CDOs of $86.5. Its not quite that simple, but its close. Anyway, if the price range of the ABX is $88 to $44, the right value of these CDO positions is no better than $60. Probably more like $30. So you'd say that Merrill's acceptance of $500 million is anywhere from 1/3 to 1/5 of what they'd have received from a well capitalized counter-party. Admittedly, I'm completely wagging these numbers, but it's safe to say this was a distressed exchange.

Merrill Lynch: We can pay you 2,000 now...

Merrill Lynch's surprise announcement on Monday that they were selling $31 billion (par) of ABS CDOs and raising $8.5 billion in common equity has financial CDS moving tighter. Credit default swaps (CDS) on Merrill are 80bps tighter since the news (from 350 to 270). Lehman Brothers is 50 bps tighter and Morgan Stanley is 30bps tighter. Merrill's cash bonds now about 35bps tighter over the last two days, with other broker bonds 2-10 tighter. The pattern of CDS being much more volatile than cash bonds has been common during the last year, as CDS tend to be the favored vehicle of fast money.

To understand why ABS CDOs which were originally super-senior could possibly be worth 22 cents on the dollar, read this post about the danger of "structure squared."

Monoline insurers are seeing an even bigger reaction. Along with the Merrill news, Security Capital (SCA) and erstwhile parent XL Capital agreed to further cut ties between the two companies. XL had previously agreed to reinsure and/or cover certain losses incurred by SCA. The two companies agreed to extinguish those agreements in exchange for $1.8 billion in cash transferred from XL to SCA. This effectively rescues SCA from likely insolvency. Separately, SCA and Merrill agreed to terminate $3.7 billion notional of CDS in exchange for $500 million in cash.

The CDS on insurance subsidiaries of all the monoline insurers are performing very well on this news. SCA CDS has fallen 10 points (equivalent to a 10% gain vs. par on a cash bond) from 33 points to 23 points. FGIC fell 6 points (to 43), MBIA fell 7.5 points (to 25), and Ambac fell 6 points (to 17).

Merrill Lynch will be providing 75% non-recourse funding to Lone Star (the buyer of the ABS CDOs). I think the correct way to interpret this is that Merrill has not shed itself of ultimate default risk. They have, however, shed themselves of mark-to-market risk. Further, some are saying that the financing indicates that the securities sold are really worth 5.5/cents vs. par (25% times the stated sale price of $22). I don't think that's the correct interpretation. The financing indicates retention of risk, not the ultimate trading value of the securities. Its common for dealers to fund client investments, and I don't think that should have a bearing on the valuation of the securities.

So what's the trade? Merrill had by far the largest exposure to ABS CDOs as well as monolines among big dealers. Citigroup was the other. Lehman, Morgan Stanley and Goldman Sachs have little to none. So the fact that Merrill Lynch has set a market for their ABS CDOs at 22 cents on the dollar matters more for Citigroup than any other big bank. ABS CDOs were also very popular among European banks.

In addition, CDS trading has been extremely volatile in recent months. Should this capital raise by Merrill touch off a short-covering rally in CDS, expect the rally in CDS to far outstrip any rally in cash bonds. Eventually cash bonds will be dragged along, as cheaper CDS protection eventually creates an arbitrage in cash bonds. Long-term buyers should watch the CDS market before putting money into cash bonds.

Finally the deal between SCA and Merrill Lynch may create a template for the workout of other CDS contracts on structured finance products. That may indeed be the glimmer of hope that some of the downgraded monolines have been looking for. The most impacted will be MBIA, which was Merrill Lynch's favored insurer. Don't get carried away with optimism here. I'd say that the odds of these companies surviving, as in, making it through run-off, have gone up slightly in the wake of this news. But I wouldn't say the stocks are worth much more.

And now young monoline... you will die

Sometimes life is unfair. Take, for example, Moody's Investor Service's ever changing criteria for a Aaa rating. On Monday, Moody's put both Assured Guaranty and FSA's Aaa rating on negative watch. This despite Assured Guaranty having excess capital, defined as 1.3 times Moody's assumed losses given a "stress" scenario, and FSA falling short by only $140 million. FSA, it should be noted, just secured a $5 billion line of credit with parent Dexia.

In both cases, Moody's cited declining use of bond insurance in general: "Bond insurance volumes in the municipal segment have also declined significantly, with insurance penetration rates dropping by a third or more." It seems Moody's has concerns that the decline of muni insurance in general is a negative for FSA and Assured Guaranty's long-term business models. Which is interesting since both FSA and Assured Guaranty have both increased their market share considerably. In Assured's case, they are writing substantially more business now than last year, and for FSA its at least close.

It still looks to me like FSA and Assured Guaranty have plenty of capital, especially given their lack of ABS CDO exposure. But it isn't my opinion that matters. So what should municipal investors do with their FSA and Assured Guaranty paper? And would a downgrade of either lead to an investment opportunity?

First, consider what "negative watch" means. In most cases, negative watch turns into a downgrade, unless some intervening event occurs. For FSA, its possible that Dexia contributes capital to bring FSA above Moody's target levels. But given that Assured is already above those levels, its not certain that a capital infusion would make any difference. So investors should assume that FSA and Assured Guaranty will be downgraded. I would also assume that S&P will eventually follow suit.

Within an existing portfolio, look at each credit in your municipal portfolio. Are there any that you own strictly because of the insurance? If so, you are probably best to get out now. Get the underlying rating of all your positions. If you are with a financial professional who cannot readily provide the underlyings... well, that should tell you something.

As far as looking for opportunities, they will be there for investors with long investment horizons. But be aware of liquidity. Institutional investors are going to be better sellers of insured bonds for some time to come. Scrutiny from the public (in the case of publicly reported portfolio) or from a board (in the case of insurance companies) will cause portfolio managers to shun bonds where a downgrade is expected. If you bid on a FSA insured bond today, the odds are fair that you are the only bidder. And what does that tell you about your ability to sell the bond yourself? If you are going to bid on a FSA insured bond, make sure you bid a price at which you are comfortable holding for the long-term.

Of course, if you do decide to look at a FSA insured bond, you need to look at the underlying rating. Until recently, the market didn't price A underlying bonds much differently than those with a AA underlying ratings. That's going to change in a big way. Investors will demand significantly more yield for an A-rated risk, even before FSA or Assured gets downgraded officially. Keep this in mind when bidding on bonds. Among non-insured bonds, the gap between A and AA is about 50bps, which is about 4% in price on a 10-year bond.

I had previously said I thought that municipal insurance would remain viable, despite the problems with FGIC, Ambac, and MBIA. I think the fact that a large percentage of new issues in 2008 have carried insurance bears that out. However, if Moody's (and S&P) cannot establish consistent guidelines for maintaining a top rating, then it will be impossible for insurers to plan for capital adequacy. Having the Aaa rating is crucial to that business, yet its unknown what the criteria will be from week to week. That's an impossible business to capitalize intelligently.

Ironically it won't be a lack of demand that kills muni insurance, but a lack of supply.

A New Monoline: Its our only hope

On Tuesday, Ambac announced it is making progress on recapitalizing its Connie Lee subsidiary. This sent Ambac and MBIA's stock prices soaring (+52% and 22% respectively) and their credit-default swaps plunging (about 6 points each). CDS on both company's insurance arms are now 20 points below the wides. What are their plans for recapitalization and what does it mean for municipal bond investors?

Both Ambac and MBIA are facing three grim realities:

1. They cannot raise enough new capital to regain a AAA/Aaa rating, especially since the ratings agencies have shifted their focus away from capital adequacy and onto financial flexibility.

2. They cannot write new business without a top rating.

3. It will take at least two years before the extent of their residential mortgage losses are known. Even given a very favorable outcome, too much time will have past for them to rebuild their franchises.

There is a faint glimmer of hope, however. Despite all the problems monolines have faced recently, there is continued demand for municipal bond insurance. During the first quarter, about 24% of new municipal issues carried insurance. Down from the historical norm of 50% or so, but still a reasonable market. So if Ambac or MBIA could just start fresh, there is some chance they'd be able to rebuild their reputations for financial strength. Its probably a long shot, but its not impossible.

The plan to get this fresh start is relatively simple. Ambac Financial Group (the parent company) plans to transfer $850 million out of Ambac Assurance Corp., which is their primary insurance subsidiary. This is made possible, ironically, because Ambac Assurance has reduced capital needs now that they are only rated Aa3/AA. The cash would go to Connie Lee, which is in essence a dormant registered insurance sub. In theory Connie Lee could operate with its own assets and liabilities, with its own relation to Ambac's current insurance operation being a common holding company owner. Hence there would be no mortgage exposure at Connie Lee. This would presumably allow for a AAA/Aaa rating and possibly the ability to write new municipal bond policies. MBIA's plans are substantively similar.

Where does that leave existing policy holders? At one time, there was talk that the new insurance subsidiary would reinsure all the existing municipal bond policies. In effect, transferring existing municipal insurance from Ambac Assurance to Connie Lee. This was legally complicated, as it would have in effect benefited one class of policy holders (munis) at the expense of another (structured finance). There would be lawsuits and the plan would get tied up in court for years. So now it appears that this kind of plan is dead in the water. Therefore even if Ambac is able to capitalize Connie Lee and get a fresh AAA/Aaa rating, there will be no direct benefit to current Ambac policy holders. In fact, Ambac Assurance will lose $850 million in capital in the process, putting existing policy holders in a somewhat weaker position.

On the other hand, if the plan were to actually work, if Connie Lee is able to start writing a reasonable amount of new muni business and therefore Ambac Financial is able to remain solvent, existing municipal bond holders will probably benefit. Over time, Ambac's structured finance exposure will dwindle, either because they realize losses or because the underlying bonds pay off. If indeed the parent company survives this process, they may be able to regain a top rating, or perhaps merge the existing Ambac Assurance with Connie Lee and regain a AAA/Aaa rating that way. Again, MBIA's plan would work similarly.

What are the odds the plan will work? It depends on how the market perceives Connie Lee vs. Ambac. Does the market think that Ambac's poor credit work was to blame? Or will the market separate the poor judgement Ambac showed in the structured finance market from their decisions in the municipal market? It will probably take Connie Lee accepting a relatively low premium and/or insuring weaker credits at least at first. Then slowly repairing their reputation. The odds are against them, but like I say, not impossible.

So how should muni investors treat Ambac and MBIA insured bonds? The reality is that any bond with an Ambac or MBIA (as well as FGIC, XLCA or CIFG) insurance is trading weaker than the underlying rating would imply. In other words, bonds are trading as though there is a penalty for once carrying Ambac or MBIA insurance. While this would seem to present a buying opportunity, be sure you can handle the illiquidity. Many institutional municipal buyers don't want to explain to their clients why they hold so much MBIA paper, so even at higher yields, bids can be hard to come by. I wouldn't expect the "penalty" to go away any time soon, so buyers of this kind fo paper need to have a long time horizon.

As far as MBIA or Ambac debt, proceed with extreme caution. Both companies are in Hail Mary mode, as current conditions have left them with very few options. In such situations, bond holders are not given much consideration by management. Preferred shareholders are in particularly precarious position, as they sit behind both insurance policy holders and senior debt holders.

The common stocks of both companies saw a significant short-covering bounce. One has to wonder about the wisdom of shorting a stock trading at $1 anyway. Common shareholders should view these latest plans as a last-ditch effort to create any kind of value for shareholders. Given that is the situation management is in, nothing more needs to be said about the risk of owning the common.

Housing Legislation: Short help

The Frank/Dodd housing proposal, while not law yet, looks to be headed there. While it seems the proposal will have some non-zero impact on the housing market, I'd vote against it. Quickly, here are my problems with the proposal:

• The key element is that the government will trade a GNMA security for a troubled loan as long as the bank holding the loan agrees to write down the principal to 85% of the assessed value of the home. This could be a very large write down in many cases. Say I bought a $300,000 home at the peak and put 5% down. Let's say the appraised value has fallen by 15%, so the house is worth $255,000. Now the bank has to write the loan down to 85% of that ($216,750) in order to participate in the Frank/Dodd program. What started out as a $285,000 loan must be written down by $68,250, or 24% of the original loan amount. Banks are going to be very reluctant to participate in this program. Why not roll the dice and hope that the borrower keeps paying?
• Given the above, any loan the bank does decide to put into the GNMA program will be of the truly toxic waste variety. So tax payer costs will be significant.
• Even if the proposal were to be signed into law today, most analysts agree that the book on 2008 foreclosures is already written. The foreclosure process is always a lengthy one, and currently servicers are swamped, so its taking longer than usual. So the proposal won't start having an impact until 2009.
• By that time, we'll be nearing a "burn out" on bad mortgage foreclosures. By this I mean, at some point, all the really bad loans from the 2005-2007 period that are going to default will have defaulted. By mid-2009, it will have been two full years since the sub-prime blowups started. That should be enough time for the overwhelming majority of the loans to borrowers who really can't afford the loan to be ferreted out. From that point on, loan foreclosures will probably be above average for a while because of the lack of equity, but the pace should decline.
• By early 2009, homes in the most bubblicious areas will be down 25-40%. So the amount banks have to write down to stick these loans to the government will be very large indeed. The risk/reward may be to retain the loans and hope that most of your borrowers keep paying, or to work out a separate modification rather than participate in the Frank/Dodd program.
• Put the last three points together, and most banks will figure they've already foreclosed on the properties they might have originally put into the Frank/Dodd program, and what remains is worth keeping.
• I'm not even mentioning the obvious moral hazard, which is another issue entirely.

So this housing proposal, at least as far as helping home owners, is a lot of political posturing without much eventual impact. So I'd vote against it.

What kind of government intervention might actually work? What the housing market needs is a reduction in supply. We're slowly getting to a place where new construction isn't so much a problem, but as I've alluded to above, I think we're about a year to 18-months away from the peak in foreclosures. So that's going to remain a problem.

Normal household formation won't soak up the supply for a while. A recent report from Lehman Brothers indicated that there will be 4 million units which need to be absorbed by the end of 2009, both foreclosures and new home construction. About 1 million can be taken down by normal household formation. That leaves 3 million homes to sell, a pretty big nut to crack.

Demand could come from either current renters becoming home owners or investors. In both cases, prices need to drop a large degree to stimulate demand for 3 million marginal homes. For what its worth, the Frank/Dodd proposal is estimated to help 500,000 home owners. That still leaves a pretty big nut to crack!

There is actually a relatively simple way for the government to help soak up this demand quickly. Make investing in a home more attractive. In other words, make buying a foreclosed property for the purpose of renting it out a more attractive investment. It could work any number of ways: there could be a large tax rebate to the investor, FHA could offer cheap loans, etc.

It could even be structured such that the financial system was strengthened in the process. Say the government allowed anyone who bought a foreclosed property to write off 20% of the purchase price on their taxes, but in order to qualify, the buyer has to have at least 20% equity in the home. The result would be a deleveraged housing sector. Most alternative proposals involve the government helping to provide down payments. But that doesn't deleverage anything, only shifts the leverage to the government.

Anyway, my idea is politically untenable, since it would help wealthy investors make money on the back of a displaced homeowner. So it isn't likely to happen. There have been similar programs enacted in urban areas, under the auspices of reducing urban blight. So it might be that some local municipal housing agencies attempt such a thing.

By the way, while I doubt the Frank/Dodd proposal helps much in terms of housing prices, it probably will help in terms of certain sub-prime securities. As I said above, banks will most likely transfer the worst of their loans to FHA under the proposal, i.e., the ones they securitized. Most of the A and BBB-rated sub-prime bonds from 2005-2007 are toast anyway, but the senior stuff trading at 50% of par could see some significant benefit. Too bad it'll be too late for Ambac and MBIA...

Sir, monolines coming into our sector!

It hasn't been a great year for monolines, and Pershing Square Capital's Bill Ackman has been one of the main beneficiaries. He's famously made a kings ransom shorting MBIA, betting that losses on collateralized debt obligations and other asset-backed securities would eventually drive MBIA bankrupt.

But now he's set his sights on far more conservative Financial Security Assurance (FSA). As FSA is wholy owned by European banking giant Dexia, there is no stock to short. Instead Ackman has bought credit default swap (CDS) protection against FSA defaulting on its insurance obligations. Currently FSA is rated AAA/Aaa/AAA by S&P, Moody's, and Fitch respectively with a stable outlook by all three.

Ackman's revealed his position at a conference in New York on June 18. The market paid attention. The next day CDS on FSA had moved 200bps wider to 700bps/year for protection. It rallied into the 400bps area two days later when Dexia extended a $5 billion credit line to FSA, but has since moved back into the 700 area. For context, this morning Lehman Brothers CDS was +280 offer, Washington Mutual was +585. To get into the 700 area you have to look at names like National City.

Does FSA belong in the same category as Ambac and MBIA? I'm going to explore this in two parts, first on the liability side, then on the asset side. Here are the raw facts on insurance liabilities.

The following chart details the direct residential mortgage (RMBS) exposure from MBIA and Ambac (blue bars) and FSA (red bar). Each is expressed as a percentage of the firm's total claims paying resources. So for example, Ambac has exposure to home equity lines of credit at 216%, which means that if their entire HELOC exposure went to zero, the firm would exhaust their claims paying resources two times over. The figures are from S&P and the companies themselves.



So looking at this, FSA is no better than its more troubled competitors. However, when it comes to direct RMBS exposure, the story isn't quite as dire as it would initially seem. The monolines' generally insured senior positions in RMBS deals, meaning that other securities would absorb losses first. For example, FSA states that their typical subprime RMBS transaction has 20% subordination and 7% excess spread, or excess interest collected by the trust for benefit of senior bond holders. In their first quarter earnings release, FSA estimated that more than 45% of all subprime borrowers would have to default (in a given deal) in order for FSA to pay a single dollar in claims.

Will any transaction suffer 45% defaults? Some probably will, but all of them won't. And the second lien transactions (both closed-end and HELOCs) will likely enjoy no recovery upon default, so those loss severities will be worse. On the other hand, the monolines have the luxury of making payments on RMBS losses over time, i.e., there is no large principal payment which would come due all at once. So RMBS losses will be substantial to be sure, but its probably manageable. But that's not where the really big problem is.

The big problem is in collateralized debt obligations (CDOs).

The key to the CDO creation game was to create the maximum return to the equity holder while still earning a AAA rating for the senior-most holder. In creating CDOs using RMBS as collateral, the arranger generally used subordinated securities. And by subordinated, I mean the first ones to take losses when the underlying borrowers default. Today it is widely assumed that most subordinated sub-prime securities won't receive any principal at all, and many subordinated prime RMBS will suffer significant impairments. So a CDO made up of these subordinate securities, even the senior-most piece of the CDO, is likely to incur large losses.

Which brings us to our second chart, RMBS CDO exposure, again as a percentage of claims-paying resources.



The reality is that most of these RMBS-oriented CDOs are going to take losses of 30% or more. CDOs alone will likely sap the resources of Ambac and MBIA. But FSA's exposure to this sector is nominal. Even if they were to take 100% losses on their RMBS CDO portfolio, the impact on their solvency will be minor.

Remember that FSA is a subsidiary of Dexia, and therefore Ackman's bet isn't on the common stock. In the case of MBIA, Ackman was able to short the common. Even if MBIA is somehow able to pull through as a solvent company, Ackman's gains on shorting the stock will still be substantial. With FSA, he's long CDS protection, which only pay off in the event of a default, so Ackman's bet is not on a decline in profitability or loss of AAA ratings, but on bankruptcy. In fact, FSA could lose its AAA ratings and Dexia could give up on the financial guaranty business and put FSA into run-off, and as long as FSA never runs out of cash, Ackman's CDS will expire worthless. Sure, Ackman could gain on CDS widening. Maybe he's already cashed in his gains on FSA. But given the already wide spread on FSA CDS, if FSA doesn't have liquidity problems, it will be an expensive short.

The facts on the insured side just don't support FSA going the way of MBIA or Ambac, particularly when you limit the discussion purely to solvency. Next up, a look at FSA's investment portfolio. (Hint, that doesn't look as rosy.)

I'll come right back and give you a hand!

Bill Ackman has gone long FSA CDS, in effect betting that FSA will go bankrupt. Its moved 200bps wider today (now 645/695). I want to write a detailed post comparing FSA, Ambac, and MBIA, so that's coming. But in the mean time, does anyone have anything more detailed on Ackman's case against FSA? If so, e-mail me: accruedint at gmail.com.

Ackman was obviously right about MBIA, but I have long contended that he's been getting too much credit for calling MBIA early. Some readers may remember he was short MBIA at Gotham Partners going all the way back to 2002, before MBIA was heavily involved in the shit that ultimately dragged them down. Don't get me wrong, kudos for him for all the money he's made on MBIA. I just bristle when I hear something like "he's been right about MBIA since 2002." His thesis from 2002 was wrong. His thesis in 2007 was dead on.

In other news, I've been contemplating some upgrades to the site, one of which would be to start using labels. Vote in the latest poll if this interests you.

What is a Tender Option Bond (TOB)?

(Alternative title for long-time readers: There's a meteorite that hit the ground near here. I want to check it out. It won't take long.)

A tender-option bond (from now on TOB) is the municipal bond market's answer to the classic borrow short and invest long. As with many types of leveraged strategies, this one has been getting hit very hard in 2007. It also has some disturbing parallels with the SIV problem which has rocked the money markets.


What is it?
First, here is what a TOB is. You start out with a long-term tax-exempt municipal bond, usually highly rated. Let's say you buy it at par with a 4.5% coupon. 30-year tax-exempt munis are widely available at that price right now.

Then you sell senior notes to some other investor with your long-term muni pledged as collateral. The amount is somewhat less than the value of the collateral pledged. The senior notes have the same maturity as your pledged collateral, but the interest rate floats every seven days. Typically the floating rate is set by a dealer firm (called the "remarketing agent") based on whatever rate will clear the market. The senior note holders also get a put option, also called a tender option. The senior note holders can put their bonds back to the issuer at par at any time with settlement on the next reset date.

If you are familiar with municipal floaters, you know this is a very common structure. It goes by the name VRDO (Variable Rate Demand Obligation) or VRDN (N=Note) or VRDB (B=Bond). It is used by normal issuers who want variable rate debt as well as TOBs. The idea that the bonds would always be puttable at par probably sounds funny to some readers, so think about it this way. It really just like a revolving CP program where the issuer retains the same amount outstanding all the time. While technically in a CP program, the old CP matures with proceeds from the new CP, as long as the capital markets are fully operational, the CP issuer effectively just resets his interest rate.

So back to the TOB. You remember the size of the senior issue was less than the size of the collateral pledged, which leaves us with some residual. That is sold to junior note holders, who in essence have leveraged exposure to the original municipal bond.

These programs can be structured as single name deals, where a single long-term muni has been pledged vs. a single senior VRDO. Or it can be structured where there is a pool of long-term munis pledged against a larger senior VRDO. From a pure safety perspective, the senior holders would obviously prefer the pool, but there are legitimate tax concerned about the pooling structure. Legally, in order for the tax-exempt status of a bond to pass through any kind of structured product, the credit risk of the municipal has to be retained by the investor. Thus the senior/subordinate structure of the TOB can get sticky, especially if its pooled. Some tax attorneys argue that when you pool this kind of program, the senior holders are not actually taking risk on all the municipals in the pool, since its usually the case that several could default without senior holders getting hurt. This senior/subordinate concept is not unlike a CDO structure in terms of how the senior notes are protected.

VRDOs are normally backed by some sort of credit enhancement, which is different than the classic bond insurance. In the case of a VRDO, the backing is normally from a bank, which can come in various forms: a letter of credit, a stand-by purchase agreement, or just a liquidity facility. All of these have similar functions for the investor: it ensures that if investors want to put their bonds back, that someone with capital is there to buy them.

The junior notes are most likely held by a hedge fund. There are many hedge fund for which this is their only strategy, and they spend most of their day creating these TOB structures. Since the junior notes have considerable interest rate risk, the hedge fund generally cooks up some means of hedging this risk. Unfortunately, the world of municipal derivatives is pretty murky, so often the hedge fund winds up using LIBOR swaps or some such as its hedge. This introduces the risk that taxable bond rates move differently than municipal bond rates.

In addition, long-term municipal bonds are usually callable by the issuer starting in the 10th year. The option risk inherent in the municipal makes hedging with non-callable taxable instruments like swaps a real challenge.

TOBs are generally created using AAA municipals as collateral. This has to do with the desires of both the senior and junior note holders. The senior holders, usually money markets, generally want very highly rated securities. Ratings agencies will generally rate the TOB senior piece the same as the underlying collateral. The hedge fund buying the junior piece also wants to avoid credit problems. The arbitrage of a TOB is all about the slope between short-term and long-term bonds. Introducing credit risk merely complicates an essentially simple arbitrage.

Now here is where the problems start...

Current Troubles
Up until now, finding AAA-rated long-term munis was easy, because so many munis were insured by AAA-rated monolines. I believe its around 40% of all municipal issues are insured. But now we're in a world where that AAA rating is imperiled. This has caused the municipal bond market to decouple from the taxable bond market, perhaps not entirely, but to some degree. Whereas historically municipals tend to trade around 80% of Treasury rates, currently the number is above 90%. Long-term municipals are widely available at or slightly above the 30-year Treasury rate.

This means two things for TOBs. First, money market funds are increasingly unwilling to hold short-term TOB debt. Makes sense right? If you were running a muni money market fund, and you could get out of any TOB debt at par right now, wouldn't you? You know that there is a decent chance some of the TOB bonds are about to be downgraded. You also know that the guy across the hall who ran your prime money market fund just got fired over the whole SIV thing. I'd dump those TOB bonds as fast as I could.

Second, the TOB hedge fund's hedge position isn't working. Municipal yields are not moving with taxable yields and this is creating big losses for the TOB. And we know what happens when hedge funds take losses: investors start pulling out. So you've seen TOB programs having to force liquidate bonds.

Bad news. TOBs represent 8% of the total municipal bonds market, or about $200 billion. The muni market isn't known for its liquidity, so if you have a large number of bonds being dumped on the secondary market, the whole market cheapens up. This is exacerbating any credit concerns market participants might be having.

Parallels with SIVs
The parallel with the SIV problem is hard to miss. Money market participants eschew the debt. Vehicle can't roll over. Winds up liquidating into an illiquid market. Exacerbates an already tenuous credit environment.

The good news is that unlike SIVs, the credit quality of municipals remains very strong. While SIVs were involved in the CDO and sub-prime markets, where there has been unquestionable and material deterioration, municipals don't really have this problem. Property tax collections may wane a bit, but the odds of this rising to a level where any cash flow to bond holders is ultimately impaired is remote. The only real problem in munis are the bond insurers. Even if one or more bond insurers were to disappear, the downgrade in most municipals would be from AAA to AA or A. Not good, but not the end of the world.

The bad news is that the bank credit enhancers may wind up owning the TOB bonds. See, if the hedge fund which is operating the TOB program can't make good on the short-term debt, perhaps because it can't liquidate all its long-term bonds and hedges at less than 100%, the bank will probably wind up possessing the underlying bonds. Again, this won't turn out like the SIV problem, where bank sponsors of SIVs are taking bonds onto their balance sheets at steep discounts. But still, cash-strapped banks are likely to just blow out the muni positions, creating more of a supply problem in the long-end of the muni curve.

Sell my Munis? Sell my muni money market?
I'm surprised to find you squeamish, monsieur, that is not your reputation. I think munis are a screaming buy for long-term holders. You are rarely going to get the chance to buy long-term munis at prices about equal to Treasuries. That isn't to say this is the absolute bottom, but I think as we finally resolve the bond insurer issue (one way or another) municipal buyers will come back in. Remember, there is no good substitute for municipals. They are the only tax-free game in town.