The big threat of muni debt

By Jon Markman

Stocks rallied in the last week of January on the hint of a glimmer of a sliver of hope that a series of big U.S. interest-rate cuts and the prospect of modest tax-rebate checks would mend all the rips in world credit and consumer-product markets and open a clear path to better days.

So far in February, though, this tooth-fairy scenario has been rudely interrupted by the harsh reality that startling dangers remain in the wings, just waiting their turn, and are likely to emerge vividly enough over the next month or two to spook investors and send stocks below their January lows and beyond. Bulls didn't really think they were going to escape bears so easily, did they?

The culprit this time is probably going to come hurtling in from a corner of the finance world least expected to give anyone grief: the formerly sleepy world of municipal finance, or the conduit through which cities and states pay for civic infrastructure. It may be hard to believe that your local roads, bridges and sewers could have a connection to the crisis that has rocked world financial markets in the past eight months, but this could be one of the worst threats yet.

Bridges to nowhere for investors?

Here's the problem: Citizens have for decades empowered their towns, states, school districts and regional mass-transit agencies, among others, to issue debt to pay for all the niceties of modern transportation, education and public health that we take for granted. These long-term obligations, which you may know as municipal bonds, or munis, are backed by civic agencies' taxation powers. The agencies nick local homeowners and other consumers for a few cents here and there on sales taxes, property taxes and use taxes, and it adds up to enough cash flow to pay off the debts.

For the most part, this is a lovely setup, and there have been ridiculously few defaults on the debts over the decades. But because virtually all local governments are treated like country bumpkins by Wall Street, they aren't accorded the top-quality ratings, known as AAA or AA, that would allow their debts to be sold to safety-seeking money market funds, private investors or overseas pension funds.

As a result, local governments for years have bought a type of guaranty known as a wrap from companies called monoline insurers. These insurance companies essentially agree to wrap their own AA or AAA ratings around the municipalities' lower ratings, allowing the bonds to be sold easily in the global marketplace. The monoline insurers thus have had one of the greatest free lunches of all time: They've collected billions in premiums from muni issuers yet rarely, if ever, paid a claim.

Because the monoline business was so profitable, the biggest insurers decided a few years back to spread their wings a little and branch out into the business of guaranteeing some riskier credits. Egged on by ratings agencies that wanted them to diversify away from the poky world of munis, executives at Ambac Financial Group (ABK, news, msgs), MBIA (MBI, news, msgs) and PMI Group (PMI, news, msgs) threw common sense out the window and persuaded their boards and shareholders that they could guarantee a new type of highly leveraged debt we have come to know as the evil villains in the past year's credit psychodrama: collateralized debt obligations, or CDOs.

CDOs, you may recall, are those bundles of high-yield securities backed by subprime home mortgages, subprime auto loans, credit cards and the like that have dripped acid all over the world financial system in the past year. As many mortgage holders have stopped making payments on loans amid rampant home foreclosures across the United States, the securities underlying the CDOs have been downgraded left and right by the ratings agencies -- in many cases from AAA all the way down to junk-bond status in a single swat.

As you can imagine, these downgrades make the CDOs too risky for pension funds to hold, but they are illiquid and hard to sell. Holders have therefore obsessed over whether the monolines would make good on their insurance policies in the event of default and have concluded they are so frightfully undercapitalized that payoffs are unlikely. So the insurers have found themselves under the microscope of ratings agencies, which have been threatening for the past couple of months to downgrade their high ratings. Because high ratings are all they have to sell, Ambac and MBI shares have plunged 84% and 79%, respectively, since early October as their business prospects have collapsed and their solvency has deteriorated.

Now this is where it starts to get ugly for cities and states -- which means you and me.

Rated ex

In many cases, munis are sold as part of "tender option bond," or "put bond," derivatives. In these programs, which became very popular among hedge funds in this decade because their low risk profiles permitted a lot of leveraging, a bond could be tendered back to the issuer if any of a variety of troublesome events triggered, ranging in severity from a default to a ratings downgrade. The programs required the issuer to buy the bonds back at par, or face value.

If the monoline insurers that guarantee the bonds lose even one notch of their high ratings, then every one of the hundreds of thousands of munis they have underwritten over the years likewise loses its high rating. And that would be an event that could lead bondholders to attempt to tender the bonds back to issuers. Only cities and states don't have anywhere near the tens of billions of dollars it would cost to buy them back. They would need to issue more debt at higher interest rates, and, well, you can see this can spiral way out of control.

Continued: A worst-case scenarios

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.