Variable-Rate Note Market Now Freezing-Sources

NEW YORK (Reuters) - Major banks, including UBS AG (UBSN.VX) and Citigroup (C.N), are making it harder for clients to sell what was considered one of the safest alternatives to cash -- so-called variable-rate demand notes -- sources familiar with industry practices say.

"I heard everybody's doing it," one of the sources said on Monday.

Previously, investors who wanted to sell these floating- rate notes just had to contact the banks, which would either resell the debt or salt it away in their inventory.

But now, because banks are afraid of taking on any more risk, they are taking advantage of the slower and more cumbersome procedures spelled out in the debt's legal papers, which oblige would-be sellers to go through the tender agents.

As a result, this $400 billion market is starting to freeze up -- much like the market for auction-rate paper -- as the banks put their need to save cash ahead of the investors' desire for them to buy their debt to keep the market liquid.

One of the main culprits causing the market for variable-rate demand notes to seize up is the troubled bond insurers that guarantee them. This is the same factor that has caused the $330 billion auction-rate note market to get hit with billions of dollars of failed auctions every day since late January.

A TALE OF TWO MARKETS

Fears that that more downgrades lie ahead for these bond insurers -- a list that includes MBIA Inc (MBI.N), Ambac Financial Group ABK.N and Financial Guaranty Insurance Co -- have led investors to unload variable-rate demand notes by the boatload.

As a result, the market for variable-rate demand notes has split in two, with credit-worthy paper at times fetching yields that are lower than the approximately 2.5 percent rate that previously prevailed for most of this debt. Less desirable notes now trade at yields of 6 percent and even higher.

This phenomenon has shocked investors because variable-rate demand notes have safeguards -- letters of credit and standby purchase agreements.

Issuers of variable-rate demand notes -- including states, cities and towns -- paid extra fees to give investors those protections, which oblige the sellers of those guarantees to buy the debt back.

In contrast, auction-rate notes have none of those safeguards, and billions of dollars of auction-rate notes have failed since late January -- which means issuers have had to pay penalty rates as high as 20 percent. Such auctions fail when there are not enough buyers.

Since early last week, the banks, which first stopped supporting auction-rate debt, have now turned away from variable-rate demand notes.

A Citi spokeswoman noted the bank had not formally resigned as the remarketing agent.

A UBS spokesman had no immediate comment.

Spokesmen for other major banks, including JPMorgan Chase & Co (JPM.N) and Goldman Sachs (GS.N), had no information immediately available. Spokesmen for Merrill Lynch MER.N and Lehman LEH.N were not immediately available.

"I had heard there was tremendous stress in the variable- rate demand notes because money market (funds) and mutual investors have been putting back a lot of their variable-rate demand notes and dealers were getting overwhelmed on their balance sheets," said Matt Fabian, managing director of Municipal Market Advisors, in Concord, Massachusetts.

This is one of the main reasons a key gauge, the SIFMA Swap Index, just leaped to 2.37 percent from 1.24 percent in the previous week, he noted.

The variable-rate demand note market is starting to break down just as issuers are fleeing the auction-rate market because they never want to have to pay penalty interest rates again. Many issuers are transforming their auction-rate debt into variable-rate demand notes -- though the fees they are paying for letters of credit and standby purchase agreements are double or triple what they were just a few months ago.

Three categories of variable-rate demand notes are outperforming, trading at yields from 1 percent to 3 percent, one market source said.

This paper is either backed by strong insurers, has no insurance or is backed by a letter of credit from a "very good" bank," he said.

In contrast, some variable-rate demand notes are trading at 6 percent or even higher -- if they are insured by a struggling bond insurer, he said.

(Reporting by Joan Gralla; Editing by Jan Paschal)

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