Market Meltdown Spreads to Municipals

By RANDALL W. FORSYTH

THE MUNICIPAL-BOND MARKET suffered a virtual meltdown at the end of last week, sending yields of top-quality tax-exempt securities to levels equivalent to corporate junk bonds.

In a scenario reminiscent of the debacles in exotic mortgage-backed securities last summer or Long Term Asset Management in 1998, hedge funds were forced to dump munis at fire-sale prices.

But unlike those previous episodes, there was no significant impairment of the credit quality of the funds' assets. The problem was a breakdown in the market's liquidity and the ability of these highly leveraged funds to obtain financing. As a result, the funds were left with no choice but to dump their bonds into an unwelcoming market.

"There are no bids," declared one muni-market veteran flatly. "I've never seen anything like it," adds Theresa Havell, the head of eponymous Havell Capital Management and a veteran of decades in the credit markets. Or, as an ever-optimistic muni salesman put it: "It was an orderly collapse."

Reflecting this distress, long-term muni bonds of the very highest intrinsic quality -- not those with bond insurance, which the market has deemed to be of dubious value -- were being dumped in distress sales at yields of 6%. For a taxable investor in a 33% bracket, that 6% tax-free yield is equivalent to 9% on a taxable security, which is what better-quality junk bonds yield.

For instance, Havell cites State of Washington general obligation bonds having a solid double-A rating -- "a step away from Treasuries" in terms of credit quality, in her estimation -- with a 4.50% coupon and due in 2030. They traded at a tax-exempt yield of 5.93% Friday. Meanwhile, the Treasury's 30-year bond yielded 4.42%, which is subject to federal tax.

Such values are attracting savvy investors such as Pimco's Bill Gross, who says he's buying munis being "regurgitated" by the funds. Citigroup muni maven George Friedlander thinks muni yields are near their peaks for this cycle.

The plunge in the muni market has been an outgrowth of the seizure that hit the auction-rate securities market a couple of weeks ago. ("The Credit Crisis Offers Some Unusual Twists," Feb. 18.) Then, ARS auctions couldn't attract sufficient bidders for these securities (which investors previously had complacently considered to be cash equivalents) because of doubts about the bond insurers backing this debt.

That, in turn, impaired another arcane part of the muni market, tender-option bond trusts, which issue short-term floating-rate notes to buy long-term munis. This borrow-short-to-lend-long tack foundered as financing costs soared following the ARS debacle. The result was forced selling by hedge funds participating in these programs.

Two further complications: Wall Street has been in no mood to provide liquidity with its own capital, and has been unwilling to bid for bonds that it gladly had sold to investors.

Moreover, many hedge funds doing the muni-bond arbitrage hedged their interest-rate risk with Treasuries. That means they got hit both ways, by losses on their long muni holdings and on their hedges, since Treasuries soared in price as investors sought this traditional haven from the continuing crisis in the credit market and the renewed swoon in the stock market, including the Dow's 316-point plunge Friday.

Elsewhere in the credit market, the collapse in mortgages has spread from subprime to the so-called alt-A sector -- loans that are supposed to be just a notch below prime quality. The collapse in that sector last week forced Thornburg Mortgage (ticker: TMA), a mortgage real-estate investment trust, to have to meet margin calls on $2.9 billion of securities backed by alt-A loans. As a result, Thornburg shares lost more than 25% of their value from Wednesday's peak to Friday's close.

One mortgage pro tells our colleague Andrew Bary that alt-A mortgage securities trade for only about 60 cents on the dollar. Even if you make the extremely pessimistic assumption that 50% of these relatively high-quality loans default, and a lender recovers 50% of the value on the defaulted loans, they still should be worth at least 75 cents on the dollar. But such is the panic gripping the credit markets currently.

The effect has been to drive investors into the Treasury market, sending yields to new lows for the cycle. Most dramatically, the two-year note's yield, a barometer of expectations about Federal Reserve policy, plunged 34 basis points on the week, to 1.623%, the lowest level since early 2003. The benchmark 10-year yield fell 26.5 basis points, to 3.517%.

Notwithstanding worrisome inflation readings, the massive dislocations in the credit market and the drumbeat of weak economic data are likely to force the Fed to continue easing, as Chairman Ben Bernanke indicated in congressional testimony last week. The federal-funds futures market is pricing in at least a 50-basis-point cut in the Fed's rate target, currently 3%, at the March 18 meeting of the Federal Open Market Committee, and another 50 basis points by the April 28-29 meeting.

Lower and Steeper: As worsening economic data and credit-market conditions boosted expectations of further aggressive rate cuts by the Federal Reserve, short-term Treasury yields plunged to four-year lows, resulting in a steeper yield curve.