UPDATE 3-U.S. tax-free bonds fall due to Merrill's problems

(Updates with new paragraph 2 about the size of the U.S. municipal bond market)

By Anastasija Johnson and Joan Gralla

NEW YORK, Oct 26 (Reuters) - U.S. tax-free bond prices slipped on Friday, depressed by concerns that the downgrade of Merrill Lynch's (MER.N: Quote, Profile, Research, Stock Buzz) credit could spawn widespread selling, traders said.

The fears about the potential fallout from Merrill's problems cast a pall over the U.S. municipal bond market, a $2.5 trillion asset class with one of the world's lowest default rates.

Worries about muni bond insurers' exposure to securities backed by subprime mortgages after MBIA Inc (MBI.N: Quote, Profile, Research, Stock Buzz) and Ambac Financial Group (ABK.N: Quote, Profile, Research, Stock Buzz) earlier this week reported painful quarterly losses also weighed on the market.

This caused prices of some of the bonds they guarantee to soften slightly on Friday.

Traders also cited fears the bond insurers may sell some of the municipal bonds they own because now they can offset income with the losses and thus no longer need the tax exemption.

Looking ahead, traders fretted about the possibility that some property and casualty insurers might sell municipals to pay costly claims from California's deadly wildfires.

But the biggest immediate factor on Friday was Merrill, because it is one of the biggest players in the $200 billion world of tender-option-bond programs.