Perhaps it is part of a "market" decision that only private rather than governmental investment is appropriate. "Starve the beast" in action.

Some of these hedge funds may be under pressure to reduce their leverage, which may be the same thing as responding to margin calls from their bankers (forcing them to sell liquid assets). Municipals are a lot easier to sell quickly than collateralized debt obligations or other similar securities.

These hedge funds may also be opportunistic, lightening up on municipals now to buy them back later when they are cheaper. The argument here relates to the failure of the auction-rate municipal market. In this market municipals appeared to get something illogical - short term interest rates for what is really long term funding. The bond would be auctioned every 28 days or so by Wall Street brokers, who would buy up any amounts that didn't sell at auction, thus supporting the market. Unfortunately, Wall Street's ability to keep buying this paper as a prop to the market disappeared this year under the weight of heavy losses on mortgage securities and the clear intention of these brokers to reduce their own leverage. Suddenly these auctions "failed", and under the legal terms the municipals were force to pay penalty rates, some as high as 20%, to the bond holders who were stuck holding the paper.

To get out of this situation, any municipal borrower who used auction rate securities is now restructuring their finance programs, and replacing this paper with true fixed rate debt at higher rates than short term, but lower rates than the penalty applied if they continue to try to auction them off (we might as well conclude that the auction rate market is now dead, maybe forever).

What the municipal finance market faces in the next month is an avalanche of fixed rate paper coming to market - 40% of the total fixed rate paper sold all last year. Buyers are just going to get swamped with all this paper, and yields are going to easily rise to the 5% range (they are already at 4.89% this morning). The hedge funds are going to take advantage of this - dump their existing paper and wait until these auctions come about so they can get better yields.

I don't think all hedge funds are abandoning municipal paper, just some of them.

Compounding systemic stress, this week also saw significant forced liquidations in the municipal bond market. This has been a hot area for sophisticated leveraged trading and derivatives strategies. Today, one can add this huge market to the List of Bubbles Burst. It is difficult to know the scope of the unfolding liquidation and resulting inventory of muni bonds overhanging the marketplace. It is easy analysis, however, to suggest that liquidity for this key market will be scarce for some time. The ramifications for municipal finances, state and local borrowings, and overall economic activity are disconcerting.

No simple repeat of LTCM fiasco
Commentary and market watch by Doug Noland

But who is making the margin calls, and why? It seems reasonable to assume that the big banks that are making the news these days are the ones making the margin calls; the smaller regional banks as a group don't seem as likely to be in that business unless I'm mistaken. The reason the parties are making the margin calls, my guess, is that 1.) They're strapped for cash; 2.) Their in-house economists are (reasonably) projecting more mortgage and commercial paper-related downgrades/writedowns/losses, and 3.) Rather than waiting for the other--or third, or fourth, or fifth--shoe to drop, they want to limit their exposure and have all their cold, hard cash on hand.

What does this mean? It suggests the following: That whoever is making the margin calls is insolvent or close to it. That they don't care that making the calls floods the market with instruments (securities, credit--read: stocks and bonds) makes the problem worse by devaluing those instruments. This is a race to the bottom and the institution that pulls out fastest gets damaged the least. And the devil takes the hindmost.

If you're a student of the causes of the great depression, it would seem that this is the point just before there are runs on the bank, and foreseeing this, the big banks are calling in their loans and foreclosing on any/everything connected to them in order to have enough reserves to stay afloat. If the market is going to get flooded (with real estate, commercial paper, municipal bonds, and perhaps stocks next?), a bank may as well pull up stakes now and let the suckers ride what's left on the way down.

is the reported revolt of municipalities against the cost to them and their taxpayers due to the overly harsh and conservative ratings given them by ratings agencies. If California's treasurer succeeds in either raising the bond ratings of muni's [and thereby lowering the yields to investors] or if a substantial portion of new debt taken on by cities simply finds another market tier where they find a different source of ratings and pay less....then large holdings in Muni's might still be safe [but watch the outcome in Vallejo!] but they sure won't pay as well. Cities are in nearly as tight a bind as the Fed's impossible stagflation dilemma: weakened property tax revenues on one side and on the other, a hike in the interest payments due to the lowered ratings their deflating housing stock has prompted. Tax free muni's are my biggest holding these days. 6% sounds weak vs inflation...until you note that you get to keep the whole darn 6% and it is steadier income than any corp. dividend. I for one like the artificially low ratings of municpals. Uh they ARE too lowly rated, right????

"These hedge funds may also be opportunistic, lightening up on municipals now to buy them back later when they are cheaper."

This is what I was thinking. Maybe they know something about the Monoliners that we do not and are adjusting positions before the excrement strikes the windflow device. If the entire sector gets washed out, it's easy enough to come back and pick out the cheaper choice cuts later.

Plus hedge funds aren't monolithic, none of them wants to get stuck holding the bag. Even if you get screwed with Munis, if you can show that you were selling them before a dive it looks better than having sat there twiddling your thumbs.

Not a good sign for the monoliners IMHO.

I've been contemplating the death of the auction rate municipal securities market and what it means.

Here we have a very obscure bond selling mechanism, instituted I think in 1988, that always had an alchemical aspect to it. Municipal issuers would bring their paper to market for short term maturities, auctioned through the Wall Street brokers. The interest rate for 30 day paper has been running about 2.5%, much cheaper than if the municipality issued long term bonds at say 4.5%.

Month after month the paper would be rolled over - meaning it was reissued at auction at every maturity. In effect it was like a long term bond, only achieving short term interest rates. The auction was propped up by the Wall Street brokers, who would buy any unsold paper that day. This was called providing liquidity or secondary support to the auction.

For 20 years municipalities could effectively bring a bond to market, but obtain short term financing costs. It was miraculous in a way, and it went on for so long that everyone thought it was perfectly normal and grown up as markets go, so it would go on forever.

But it did not go on forever, because one day the brokers hadn't the ability to support the market and a fatal flaw was revealed. Now these municipalities have to go through the pain of issuing true long term bonds at much higher rates. It is likely that this auction device is dead forever, joining a list of securities market mechanisms in some big finance graveyard in the sky.

This "awakening" is at the center of all of our current market breakdowns. Things which seem miraculous will not go on forever. You cannot securitize mortgages and expect to maintain the strict credit standards that existed in the old days when the lender kept the loan to maturity. You cannot issue default insurance, called credit default swaps, on many multiples of the actual bond exposure being insured, without somebody getting into terrible trouble when they try to purchase the bond for hedging purposes. You cannot assume that at all times there will be investors out there to buy the private equity takeover financing that you hope will only be on your bank's books for a month or two.

The finance industry assumed away basic risks or ignored them. The industry extrapolated from the past 10 or 20 years of good economic times and projected a future that would look just as good for the next decade. This myopia and shortsightedness and simple inability to recognize that what they were selling was a miracle cure - homeopathic banking if you will - is costing everybody dearly.