The Credit Crunch Squeezes Municipal Bonds

Troubles in the auction-rate market pinch institutions, but bond insurers get a needed reprieve.

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Municipal bonds help cities, hospitals, museums, and universities raise cash to build bridges, new dormitories, and wards. They are generally considered some of the safest investments available. But the subprime sludge that has muddied so much of the market is now sloshing around in the arena of municipal debt. This month, hundreds of auction-rate bonds—long-term debts that see their interest rates reset through a dutch auction every one to 35 days—have failed to find bidders.

The market has stumbled as investors fear they'll be stuck with securities they can't sell, says Tony Crescenzi, chief bond-market strategist at Miller Tabak in New York. Investors are shaky on the future of bond insurers and the impact their housing-related troubles might have on the securities. The current market, Crescenzi says, has a general distaste for long-term securities that return to market frequently.

Traditionally, highly rated bond insurers like Ambac Financial Group and MBIA have helped municipal issuers bump up a security's credit rating and snag a better interest rate. But insurers that stuck their hands in the higher-yield housing market, by insuring securities tied to mortgages, have been under pressure as ratings agencies like Moody's and Standard & Poor's have raised capital concerns. An S&P announcement February 25 brought some relief, as it affirmed the AAA rating of both Ambac and MBIA.

The $330 billion auction-rate market has been appealing to issuers because they can avoid annual fees associated with obtaining letters of credit from banks, and the short-term resets generally provide favorable rates.

The Port Authority of New York and New Jersey and Carnegie Hall were among the issuers that saw auctions fail in February. The failures have stuck some issuers with interest rates as high as 15 or 20 percent, leaving many scrambling to refinance, a pricey and frustrating process.

Atlantic Health in Morristown, N.J., has been borrowing in the auction-rate market for more than 10 years, but when auctions began failing, the hospital system saw rates on $350 million of debt head from 3 percent toward a contractual penalty rate of 12 percent, says Kevin Shanley, Atlantic's CFO. Those rates have come down a bit as some investors—drawn by the recent high rates—have been bidding in the marketplace. "We're going to get set to get out," Shanley says. "Unless this thing reverts to where it was, there's no point in me being there. I can borrow cheaper in the long markets."

Barry Morrison, vice president for business affairs and treasurer of Bryant University in Smithfield, R.I., has also been trying to convert about $50 million in auction-rate securities, after the bonds' insurer was downgraded and could no longer boost the school's underlying rating. "When the insurance company is no longer a Triple-A, but the same rating we have, why'd we buy insurance?" Morrison says.

Crescenzi expects the auction-rate market will go the way of structured investment vehicles, or SIVs, which held about $400 billion in assets before short-term debt markets lost their liquidity last year. He figures that "we'll probably see half the market disappear," as auction-rate securities simply lose viability in the aftermath of the credit boom.

In the meantime, Ambac is reportedly working on a plan to raise about $3 billion. Insurers are also looking at splitting their municipal debt divisions from those dealing with riskier securities. And in Washington, House Financial Services Chairman Barney Frank, a Massachusetts Democrat, has called a rare hearing on municipal bonds. Frank says he's concerned that municipalities, facing a decline in property-tax revenues because of dropping home values, would slow investment in infrastructure and other key expenses.