By Joan Gralla

NEW YORK, March 13 (Reuters) - Banks might be the U.S. muni market's next threat if they no longer need tax-free income because one of the few happy side products of their profit meltdown is an abundance of income-shielding tax losses.

This could prompt them to sell billions of dollars of municipal bonds that they now have salted away in tender option bond programs, sometimes as part of their capital.

"Banks that built up tender option bond programs as part of managing their tax liability now have losses," explained Evan Rourke, a portfolio manager at M.D. Sass in New York.

"There's no need to have that (tax advantage) at this point and they might end up selling those portfolios," he added.

Many big banks used tender option bond programs, which buy long-term municipal bonds and pay for them with low-cost short-term notes.

But short-term rates spiked in February, partly due to concerns about whether bond insurers were still credit-worthy. This increased borrowing costs for many issuers, prompting them to start switching to fixed-rate debt from floating-rate debt.

Fears of this coming supply deluge pummeled the long-term tax-free bond market, sending yields soaring at one point to 30 percent above what Treasuries offered -- though investors must pay taxes on T-bonds.

As a result, tender option bond programs got slammed as both short-term and long-term yields turned against them.