January 25, 2008 / 10:54 PM / 12 years ago

U.S. tax-free funds liquidate bond insurer exposure

NEW YORK, Jan 25 (Reuters) - U.S. tax-free money market funds are selling insured variable-rate municipal notes amid fears that multiple-notch downgrades of troubled bond insurer ratings could hurt liquidity in the market.

The selling is driving up borrowing costs for some U.S. municipal issuers as yields on their daily notes have reset to 4 percent to 4.5 percent from the usual level around 2.5 percent.

“We are looking to take our position down to zero,” said Steven Shachat, senior portfolio manager at $870 million Alpine Municipal Money Market Fund in Purchase, New York. The fund has liquidated most of its assets insured by Ambac, MBIA, FGIC and XL Capital Assurance, Shachat said.

U.S. tax-free funds buy variable-rate demand notes sold by U.S. states, cities and counties to fund public projects from roads to schools. The funds had $482 billion in assets, based on latest figures by iMoneyNet.

Money market funds must have 95 percent of their assets in highly rated liquid securities, and portfolio managers are preemptively selling assets that might not be eligible for the portfolios if bond insurers are downgraded.

Rating agencies are reviewing the top “AAA” ratings of monolines amid concerns that subprime mortgage-related losses will leave the guarantors without enough capital to pay obligations on securities they guaranteed.

Ambac Financial Group’s ABK.N insurance unit last Friday became the first company to lose its “AAA” rating. Fitch Ratings cut Ambac two notches to “AA” and this week also slashed to “A” the top rating of XLCA, a unit of Security Capital Assurance (SCA.N).

Ratings of MBIA Inc. (MBI.N), and Financial Guaranty Insurance Co., partially owned by Blackstone Group (BX.N), are under review for downgrade by all three rating agencies.

Many of variable-rate demand are insured, but to be money market fund eligible they also have to have a liquidity facility such as a standby purchase agreement.

These agreements typically include provisions that allow the providers to walk away depending on the severity of the insurer downgrade.

“All the selling by money market funds is the fear that the liquidity will fall away,” Shachat said.

Although some selling has been going on for a while, it intensified this week after a double-notch cut of Ambac’s rating by Fitch on Jan. 18.

“Enough money market funds are doing it that they are putting significant pressure on the broker dealers and banks to provide liquidity to take back that paper,” said Ben Thompson, principal at Samson Capital Advisors in New York.

“This is then causing the dealers to raise funding costs for leverage players and issuers. Where an issuer would normally pay 2.5 or 2.6 percent for an overnight rate, today they are paying 4 percent or 4.5 percent,” he said.

For example, daily-notes sold by “A2”-rated Orange County Health Facilities Authority in Florida with a standby purchase agreement from Dexia and insurance by FGIC yielded 4.80 percent on Friday versus 3 percent a week ago.

Meanwhile, demand for securities that have their own “AAA” rating has surged. Top-rated Montgomery County, Maryland, notes with a standby purchase agreement from Dexia on Thursday yielded 2.08 percent versus 2.85 percent last Friday.

Market participants said some insured notes are trading at yields as high as 6 percent, which creates buying opportunities for some investors, Thompson said.

Said Rafat, managing director at Fitch Ratings, said that some of the money market funds rated by Fitch have been selling assets they deem at risk, but liquidations have been orderly.

“To this point we’ve not seen any material impact on the net asset values of the funds that we rate,” Rafat said. (Editing by Leslie Adler)

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