Morgan Stanley presses leveraged muni clients

By Joan Gralla

NEW YORK (Reuters) - Morgan Stanley on Thursday said it was looking for substitute funding for its leveraged U.S. municipal bond players whose borrowing costs have spiked, but some clients said they were being forced take back securities.

The $2.6 trillion muni market has been hit with hundreds of millions of dollars in sales from market participants who are being driven out of their positions because of the rate spike and banks' desire to use their capital for other purposes.

On Thursday, just two sellers were trying to unload $700 million of bonds as their short-term financing costs jump: an insurance company offered a $500 million list and another player had an approximately $200 million roster.

One expert said the lists of municipal bonds for sale could be in the billions of dollars.

Short-term rates are soaring due to fears that banks that helped finance the deals or provided liquidity facilities for notes will be downgraded because their stocks are falling, according to a muni analyst and two money managers.

"The market is in complete disarray," a money manager said.

Money market funds are adding to the pressure because some are "putting back" or rejecting variable rate demand notes backed by banks whose credits they fear will be cut. This is the same strategy these and other players used earlier this year when they spurned another kind of municipal floating rate paper, auction rate securities, because they feared bond insurers who guaranteed it would be lose their "AAA" ratings.

The financing situation for muni players who bet with borrowed money is exceptionally fluid, another source said.

"We're working with clients and trying to get them funding," a Morgan Stanley spokeswoman told Reuters.

Soaring short-term yields are punishing taxpayers because many states, cities, hospitals and other issuers replaced their auction rate paper with variable rate demand notes after the auction rate market began failing in January.

Tax-free variable rate demand notes whose interest rates reset every day now yield 7 to 8 percent, an uncommonly high level. On Wednesday, yields for this debt that reset every week shot up 300 basis points to 5-1/4 percent.

Although the variable rate demand note market temporarily froze after the auction rate market died, it later calmed down because this paper has a so-called hard put. That means it is backed by a liquidity provider, often a bank, which agrees to always buy the paper back, in return for a fee. But the business of providing liquidity no longer appears as attractive to banks eager to preserve their cash.

On Thursday, the selling pressure slammed some long-term U.S. tax-free bonds, sending their yields up to 14 percent above a widely used taxable benchmark, the London interbank offered rate benchmark.

By this comparison, 25-year muni bonds with a top-notch credit rating were doing even more poorly than in February, when the gauge topped Libor by 10 percent during one of the market's worst-ever monthly performances.

In February, just as now, tender option bond programs are featured on the roster of leveraged players who are being forced to sell -- or getting stuck with muni bonds that were part of banks' programs, market experts said.

Tender option bond programs are viewed with great trepidation because these accounts can run in the hundreds of millions of dollars.