For the love of Muni.

For the love of Muni.

Below is a reprint of comments we made on December 2nd regarding the municipal bond market in the US. And the following link is the December 9th publication to our Currency Currents Professional members where we discussed a variety of risks to the US economy.

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Taken from CCPRO 2 December 2010

Continued pressure on housing will continue to pressure state and local governments as tax revenues fall further…which reinforces the potential for a blowup in the municipal bond market…

Toil and trouble brewing in all those “safe” muni bonds! If you own municipal bonds and think they are safe, we think you should think again…
Excerpts from, “The Municipal Bond Bubble,” December Issue of Reason Magazine, witten by Veronique de Rugy:

 Since 2000 the total outstanding state and municipal bond debt, adjusted for inflation, has soared from $1.5 trillion to $2.8 trillion. The recession didn’t slow the spending.
 One reason for higher demand is the belief in safety of munis; the historical default rage has averaged just 0.01 percent annually from 1970 to 2006.
 According to the Investment Company Institute, $84 billion went into long-term municipal bond mutual funds in 2010, up from $69 billion in 2009. And the 2009 level represents a 785 percent increase from the 2008 $7.8 billion.
 Cities and states increased debt dramatically starting in 2008 thanks to a Fed subsidized program “Build America Bonds.” This puts the US Treasury on the hook for 35 percent of bond interest payments.
 The parallels with the housing bubble are growing. Remember those low-risk mortgage backed investments? Like homeowners, states and cities splurged on debt and found inventive ways to get around borrowing limits to finance projects they couldn’t pay for otherwise.
 “Spreads on CDSs have been growing, and the dollar amount of CDSs on municipal has grown in the last year. That’s a clear warning sign that people are effectively starting to short the muni market,” said Brian Fraser, of Richard Kibbe & Orbe LLP.
Municipal Bond Exchange-Traded Fund (MUB) Daily: Turning over again…

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And here is a new chart of MUB as an update:

It has broken down from around 102 to about 97.

Yesterday was indeed a rough day for muni bonds. Fear of potential default is perpetuating a self-reinforcing cycle that’s leaving investors skittish on muni bond funds and inciting capital outflows. A muni bond offering in New Jersey was pulled this week in fear of fear, basically. And Vanguard has taken back a request it made to introduce three new muni bond ETFs.

Also, here is a Wall Street Journal article discussing CDS on muni bonds and the potential for derivatives to create more volatility, more uncertainty, more fear among retail investors.

For the first time in two years, Switzerland’s UBS AG has begun making markets in derivatives tied to municipal bonds and other securities. The credit-default swaps obligate swap sellers to compensate buyers if a municipal issuer misses an interest payment or restructures its debt.

Separately, five large derivatives dealers—Bank of America Corp.’s Bank of America Merrill Lynch, Citigroup Inc., Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and Morgan Stanley—met last month in New York to discuss standardizing the paperwork for "muni CDSs" in an effort to attract more buyers and sellers.
The issue is politically explosive. States and cities are suspicious of CDSs, saying they encourage speculators to bet on, and at times worsen, states’ financial distress.

Right now the saving grace could come with continued improving sentiment over broad US economic numbers.

Have a good weekend!