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Mortgage Crisis Spreads to Muni Bond Funds

Hedge funds and prop desks holding mortgage bonds are selling munis to raise cash.

The subprime mortgage crisis is spreading to an unlikely place -- municipal bonds.

Muni bonds, which are debt obligations issued by state or local governments, are the latest type of asset to get hit as investment banks and hedge funds holding nearly worthless mortgage bonds scramble to unload anything they can in order to raise cash.

Nearly every category of muni bond funds tracked by Morningstar fell in August, with the high-yield, or below-investment-grade, category tumbling the most, 3.16% as of Thursday's close. That wiped out all of the gains they had made this year, leaving them down 2.54% for the first eight months.

Among funds carrying investment-grade munis, those holding California and New York long-term muni bonds posted the biggest declines, 1.32% and 1.12%, respectively. For the year to date, they are down 0.94% and 0.64%, respectively.

Muni bond funds weren't the worst performing category last month -- that place was reserved for precious metals funds, which lost an average of 8.22%, leaving them down 3.61% for the year.

Muni bonds might seem like an unusually staid investment for high-flying hedge funds. They tend to yield less than comparably-rated corporates, but their tax-free status tends to appeal to wealthy retirees.

But these securities provide the foundation for a popular hedge-fund strategy called tender-option-bond programs: Hedge funds and the proprietary trading desks at investment banks buy long-term, higher-yielding muni bonds, paying 4.5% for example, and put them in a trust, where they are used as collateral to issue short-term commercial paper paying a much lower rate of interest, say 2.5%. These investors pocket the spread, or difference between the two rates. They can also boost profits by buying the muni bonds with leverage, or borrowed money.

Investment banks have been using this strategy for at least 20 years, but it has become more popular over the last seven years or so, making hedge funds increasingly important players in muni bonds. Earlier this year, before the tender-option-bond programs started backfiring, investors using this strategy accounted for about 8% of the $2.4 trillion market, according to Municipal Market Advisors, an independent research and strategy firm.

When the subprime mortgage crisis picked up steam last month, hedge funds, banks and other investors found few buyers for the repackaged collateralized debt obligations, or CDOs, they had bought from mortgage lenders. With prices falling and no buyers, they found themselves in a liquidity crunch when the margin calls came. Because they couldn't sell what they wanted, they sold what they could, sparking the stock market's August swoon. But it wasn't just stocks, they also sold munis.

Adding to their troubles, a common strategy for hedging their exposure to munis backfired. Hedge funds that are "long" muni bonds typically offset this exposure by going short, or betting on declines, in Treasuries, since the two asset classes often move in tandem. But a funny thing happened, the hedge didn't work. As stocks and munis fell, investors flew to safety by purchasing Treasury bonds. Instead of falling with the munis, Treasury prices rose. The hedge not only didn't protect them, it made things worse, forcing them to sell more munis.

In a normal market movement, that

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hedge works fine," says James McCullough, senior regional sales manager for the Aquila Funds'

(OFTFX)

Tax-Free Trust of Oregon (ORTFX). "But we have an abnormal market situation and in that these best-laid plans don't work."

The selling reached a crescendo around midmonth, when one player reportedly offered $300 million in long-term muni bonds for sale. Investors unloading large quantities of bonds typically try to break them up into smaller chunks and spread the trades out over several days to avoid disrupting the market. They may even parcel the trades out to multiple brokers. Putting such a large amount of bonds up for sale at once smacks of desperation.

The offer had a profound impact; liquidity in the muni bond market, which is normally relatively active, dried up. Thomas Doe, president of Municipal Market Advisers, says that the following day, there were no buyers; investment banks were telling their trading desks not to buy at any price.

"We haven't seen a day like that since 1994," he says.

Selling by hedge funds and prop desks isn't the only thing hurting munis, however. Local governments have also flooded the market with a record amount of new issuance. For the first half of the year, short- and long-term municipal securities issuance from state and local governments surged 27% to an all-time high of $249.0 billion, according to the Securities Industry and Financial Markets Association.

"It was a perfect storm," says Bryan Williams, managing principle at Rockwater Hedge, a managing member of municipal arbitrage hedge funds in Newport Beach, Calif. "The dislocation that occurred was greater than 9/11 or the Asian crisis in 1998. We can't find any historical parallel for this. Because

the market's being sold for other reasons than value, triple-A municipal bonds are mispriced and this has created a tremendous buying opportunity."

For the first time in years, the yields have diverged, with munis paying a higher interest rate than Treasuries. Typically, because the interest paid on Treasuries is taxed, they yield more than munis.

"This is a very good opportunity to buy munis," says Bill Walsh, president of Hennion & Walsh, a Parsippany, N.J., broker-dealer that specializes in muni bonds. "If you invest $100,000 in both munis and Treasuries and they both pay 5%, that's $5,000 at the end of the year. But a New York state resident gets a triple tax deduction (local, state and federal) with a New York muni, making that worth about $8,000 of a taxable bond."

Williams of Rockwater Hedge says triple-A munis are likely to recover faster than some other asset classes that have been battered by the mortgage bond crisis, such as stocks. "The likelihood of another selloff is high, but it won't be huge. The smart money will move back into munis in a big way in the near future. So, if you're looking to make an investment in munis, the prices could get a little cheaper, but the price today is very good."