Minor Rule Change Likely Sparked Muni Chaos

The municipal bond market is suddenly imploding, creating chaos, and forcing borrowing costs from 3 percent to 20 percent during the last few weeks for many government bodies.

The reasons for this are not well known – but are actually pretty straightforward.

Last March, in a move little-noticed by the business press, the Financial Accounting Standards Board (FASB) determined that so-called "cash equivalents” should be removed from corporate balance sheets and cash-flow statements.

Corporations have responded by fleeing the market, so their balance sheet cash positions would not take a massive hit, experts tell MoneyNews.

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The crisis accelerated in recent weeks when Goldman Sachs, Merrill Lynch, UBS AG, and Citigroup ceased using their own capital to support municipal bond auctions, as they were for most of January of 2008 and December of 2007.

"If municipalities need to raise capital in the debt markets, chaos will continue until Eric Dinallo, New York state’s top insurance regulator, perhaps Congress, at some point, and the free markets sort this out,” says Peter Miralles, president of the financial planning firm, Atlanta Wealth Consultants. "Order must be restored.”

The market for auction rate securities (ARS) was worth about $342 billion last year. These long-term bonds pay lower interest rates, as their interest rates are traditionally set through auctions. Interest rates for these bonds reset every seven, 28 or 35 days.

Cities that issue ARS are now suffering because, during the last month or so, auctions have failed. While interest rates were but 3 percent late last year, they are now at 20 percent.

One firm, Citizens Property Insurance, Tallahassee, Fla., reportedly saw the rate that it pays of a part of its $4.75 billion in securities balloon from 5 percent to 15 percent on February 13 when an auction managed by UBS flopped.

What’s more, investment banks that have managed the muni bond markets, are, moreover, refusing to let investors withdraw their funds.

"Banks are not providing the liquidity and price stability necessary for securities to have successful auctions,” says Alan Klayman, CEO of MyIncomeStrategy.com, a financial planning firm.

Since corporate demand for ARS issues has evaporated, banks, at first, took on the inventory. But as the credit crunch continued – fostered by the sub-prime loan mess – Wall Street changed its mind.

"The capital commitment required to do this grew at the same time the banks faced challenges from other parts of the credit market,” says Peter Cohan, a professor of management at Babson College.

This is akin to what would have happened in the old days – before computer trading – if all the specialists on the New York Stock Exchange had stopped providing liquidity to that market, says Klayman.

Thus far this month, hundreds of municipal bond auctions have failed. This has raised speculation of bid rigging in some parts of the financial news media, and at the Securities and Exchange Commission as well.

Look for Warren Buffet to rescue the muni market, where states and local governments raise funds for infrastructure projects, soon, experts tell MoneyNews.

"Warren Buffett is starting an insurance company to insure municipal debt,” says Miralles, of Atlanta Wealth Consultants. "A year or two from now, this will be a footnote in history.”

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