The big threat of muni debt

It's one thing for corporate bonds to run into trouble, because they are typically backed by hefty amounts of assets that can be sold, even if that must happen at rock-bottom prices. And besides, there just aren't that many corporate bonds in the country: If they were all listed in a telephone book, it would be around three-quarters of an inch thick. But there are hundreds of thousands of U.S. muni bonds -- at least enough to fill a 9-inch-thick telephone book -- and cities can't just sell a bridge or sewer line or school building to raise money to pay them off in a crisis.

Let me give you an idea of the magnitude of the worst-case scenario: When ratings agency Moody's put the rating of monoline insurers Ambac and MBIA on downgrade alert last month, it was obligated to, in turn, put about 1,000 structured finance issues -- those CDOs and the like -- on "negative watch," which is a way of telling holders to beware of downgrades of their own. This is exactly what led in turn to banks' headlong efforts to get in front of the crisis by writing down the value of those issues and take multibillion-dollar losses, putting their shares in free falls.

What got less publicity was the fact that Moody's put 60,000 munis on negative watch at the same time for each monoline insurer. And when another ratings agency, Fitch, downgraded a much smaller privately held monoline called Financial Guaranty Insurance, it was forced to put 114,560 municipal bonds on negative watch.

Waiting for another bailout

According to credit market analysts at BCA Research, most tender-option-bond programs are protected with backup lines of credit in case of stress. But as we discovered in December when big banks' CDO-based structured investment vehicles, or SIVs, came under attack, those lines of credit tend to vanish on technicalities when most needed. BCA points out that banks are fighting their own battles to preserve capital and are loath to allow drawdowns on credit lines.

The analysts warn that actual downgrades of the major monolines would force those holders of tender-option-bond derivatives to unwind their munis into an illiquid market. Those downgrades are nearly inevitable unless federal or state governments mount a much larger bailout plan than has been previously discussed.

Though it's unlikely any munis will actually default, or "break par," since local governments tend to pay their bills even in recessions, they will suffer short-term losses in estimated value that will really scare folks.

On top of that, of course, you have an additional $150 billion in losses from CDOs and subprime loans left to be written down both at banks and at their counterparts worldwide. And finally, fears of payment stress have led the new-issue market to virtually shut down, closing off financing opportunities for economy-boosting investment opportunities like plant expansion and home buying except for people with the very highest credit ratings.

BCA insists it doesn't want to inflame investors, but it called its report "From the Edge of the Abyss." And a subheading in its Feb. 4 report is puckishly titled, "Are we (insert bad word)?" That's the kind of gallows humor you can expect at a time like this. Only no one is laughing. I continue to recommend that you avoid buying stocks in the financial-services sector until at least summer, and possibly until next year, using any near-term rallies up to, say, the 1,400 level of the S&P 500 Index ($INX) to sell positions you already have.

Fine print

To learn more about municipal bonds, visit Bondsonline.comor Municipalbonds.com. To learn more about tender-option-bond programs, visit this site. The blog Accrued Interest has been covering the tender-option bond problem as well as other credit issues. Visit a December post on the subject here. . . . To learn more about Ambac, click here. To learn more about MBIA, click here. To learn more about Financial Guaranty Insurance, click here. . . .

Money market funds were big buyers of tender-option-bond derivatives and munis in general. Click here to read my column about the problems at money market funds.

Meet Markman at The Money Show

MSN Money columnist Jon Markman is among more than 120 investment experts sharing their strategies for 2008 at The World Money Show in Orlando, Fla. Meet Markman in person at the MSN Money booth at 1 p.m. ET today, Feb. 7; 3 p.m. Friday, Feb. 8; or 1 p.m. Saturday, Feb. 9. Admission is free for MSN Money users. For registration information, click here.

At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.

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