July 22, 2008 / 7:09 PM / 11 years ago

US munis fall on triple play of FSA, AGO, Wachovia

NEW YORK, July 22 (Reuters) - U.S. municipal bonds fell hard on Tuesday and once again the main trigger was worries that bond insurers will lose their top-notch ratings, which could spur waves of selling by fearful investors.

Another factor that could scorch muni bond prices also arose on Tuesday, turning the risks into a triple play.

Three credit agencies downgraded Wachovia Corp WB.N’s debt ratings, citing the risks of more mortgage losses and difficulties raising capital.

“I think the market just seems to be in complete shambles today,” a New York municipal bond trader said. “And I think it’s all precipitated by the two insurance companies plus the Wachovia downgrade,” he explained.

Wachovia backed variable rate demand notes and investors in this paper now might overwhelm the market with sales, he said.

Several bond insurers this year have lost the highest ratings their business demands, shaking confidence in the $2.6 trillion muni market. As a result, the muni market turned in one of its worst-ever showings in February though this debt, sold by states, cities, hospitals and museums, has an overall default rate of less than 1 percent.

This time, the anxiety centers around two bond insurers — Financial Security Assurance (DEXI.BR) and Assured Guaranty Corp (AGO.N). Late on Monday, Moody’s Investors Service warned it might cut their “AAA” ratings, partly due to mortgage-linked plays.

These warnings could clip prices for top-rated municipal bonds in the secondary market by 7 basis points or so when Tuesday’s trading ends, a New York muni strategist estimated.

If Moody’s does indeed downgrade FSA and Assured, there would only be one “AAA”-rated bond insurer left: Berkshire Hathaway (BRKa.N). But Warren Buffett’s company so far has not displayed much interest in insuring new muni issues.

Investors, especially money market funds, now might sell variable rate demand notes guaranteed by FSA and AGO, for the same reasons they could unload debt backed by Wachovia.

“I think some of the money market funds held the belief that FSA was going to be impervious to a downgrade. That’s not the case,” said Chris Ihlefeld, a co-portfolio muni manager at Thornburg Investment Management in Sante Fe, New Mexico. The same selling could hit AGO-backed notes, he said.

The market “absolutely” could get slammed again with the liquidity problems seen this spring, he added, depending on whether ratings on FSA and AGO are cut — and how severely.

Variable rate demand notes are backed by letters of credit and standby purchase agreements, which were supposed to ensure that investors could always sell this debt. But security in this $400 billion market vanished in February when dealers got hit with too much paper backed by troubled bond insurers.

The variable rate demand note market snarled after the $330 billion auction rate paper broke down, again due to fears that the bond insurers that guaranteed it would be downgraded. Auction rate paper is long-term debt whose rates reset periodically, but it lacks the safeguards of variable rate paper.

After bond insurers MBIA Inc (MBI.N) and Ambac ABK.N lost their “AAA” ratings, investors flocked to FSA and AGO, which raised their premiums. But now, issuers increasingly might skip insurance, especially if credit agencies harmonize their often lower ratings for munis with corporate debt ratings.

“Although both companies (FSA and AGO) have pledged to work to rebuild rating agency credibility, Municipal Market Advisors feels this may well be the end of bond insurance as we know it,” wrote Matt Fabian of Concord, Massachusetts-based MMA.

On Tuesday, the county seat for Dallas, Harris County, changed its mind and opted to sell $322 million of debt without buying bond insurance, according to a market source.

Buying insurance from FSA was expected to let the Texas county shave 3 to 20 basis points off the interest rates it would pay, the market source said. AGO’s backing would have saved it an estimated zero to 20 basis points.

But then Moody’s issued its warnings and underwriters found that “they (the customers) prefer unenhanced on Harris,” the source said. The term unenhanced means without bond insurance.

FSA and lead underwriter Goldman Sachs declined comment.

County officials and AGO representatives were not immediately available to comment. (Reporting by Joan Gralla; Editing by Jan Paschal)

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