Municipal gas debt pegged to Lehman tumbles

NEW YORK (Reuters) - Bids for just over $700 million of municipal gas bonds pegged to Lehman Brothers fell on Thursday, and the investor declined to sell at that steep a discount, a fund manager said.

Prepaid natural gas bonds are a $30 billion niche of the U.S. municipal bond market that developed a few years ago to help utilities manage their energy bills by prepaying for supplies. Investment banks profited by underwriting the debt and supplying the fuel via their commodity arms.

Georgia's Main Street Natural Gas bonds are the only ones Lehman helped bring to market and they have fallen much more steeply this week than the rest of the sector, which is down around 5.0 percent or so this year due to concerns about the investment banks' strength, estimated Josh Gonze, a managing director at Sante Fe, New Mexico-based Thornburg Investment Management.

One $3.6 million block of Georgia's Main Street Natural Gas was bid at just $56 for each $100 of par value, according to Gonze. "That corresponds in yield to the range of 13 to 14 percent," he said. "It's a disaster for the investor," Gonze added, noting the debt did not trade and offers from five dealers ranged from $87 to $94.

These issues traded from $95 to $99 throughout August and into early September, which means the price was "well-established," Gonze said.

The survival of investment bank Lehman Brothers was called into question on Thursday as chief executive Dick Fuld scrambled to sell assets to cover losses from toxic real estate investments, sending shares down as much as 42 percent.

The low bids for the municipal gas bonds on Thursday was one example of how the $2.6 trillion muni bond market is reacting to concerns about how long it is taking Lehman Brothers to shore up its balance sheet.

Another issue is the municipal swap market, which totals hundreds of billions of dollars. Issuers and swap experts said they were monitoring the health of Lehman and other banks. A Lehman spokesman declined comment.

"The counterparty concern was a low level concern for municipal issuers a year ago. Today, it is among the highest of concerns," said Peter Shapiro, a managing director at Swap Financial Group in South Orange, New Jersey. He noted muni issuers are not only diving into the fine print of their swap contracts but also assessing whether they need new counterparties, if only because they concentrated many of their deals with just a few banks.

Issuers use swaps to lock in favorable interest rates, though Alabama's Jefferson County suffered after the auction rate market froze.

Shapiro and George Majors, a New York-based managing director with Bond Logistix, another financial advisor, noted that in many instances issuers would owe Lehman money if they ended their swaps. That is because issuers typically pay fixed rates and get back floating rates.

If long-term fixed rates rise, however, investment banks, such as Lehman, would then owe the municipal issuers money.

"If Lehman weathers this but people feel like the next shoe could drop at any moment, my clients will be looking to see what their options are to get out on a negotiated basis even if it costs them money," Majors said.

Kevin Kone, assistant deputy airport director for capital finance at San Francisco International Airport, said he was monitoring the market carefully.

"I did have a conversation with Lehman," Kone said. "My banking relationship managers with Lehman Brothers and SFO (the airport) confirmed that things are business as usual for them. Unless I hear otherwise I'm not going to enact any kind of plan to move anything."

The airport's debt is issued by the San Francisco Airport Commission, which has two swaps through Lehman for about $173 million. Kone said he has no immediate plan for transfers. "I'm going to wait a little bit and see what's happening in the market."

(Reporting by Jim Christie in Chicago, Karen Pierog in Chicago, and Joan Gralla in New York)