February 23, 2008 / 12:00 AM / 12 years ago

Another short-term US muni market starts to freeze

NEW YORK, Feb 22 (Reuters) - Some of the same hazards that caused the U.S. auction rate market to collapse are now spilling over into a supposedly safer cousin.

Known as variable rate demand notes, this short-term debt vehicle was designed to protect investors from the risk that their cash would be frozen if no one else wanted it.

Variable rate demand notes are backed by letters of credit, which improve the debt’s rating, or standby purchase agreements, which oblige agents to repurchase the paper.

But now some repurchase safeguards are fraying — partly because the notes are tied to bond insurers whose faulty subprime mortgage plays could cost them their “AAA” ratings.

“Variable rate notes are considered the highest standard in liquidity, and when you start to see these things stop functioning normally, you have to know something’s wrong,” said Chris Ihlefeld, a co-portfolio manager of muni debt at Thornburg Investment Management in Santa Fe, New Mexico.

U.S. states, cities and agencies sold around $60 billion of variable rate demand notes in 2006, according to Thomson Financial. These notes can vary widely, depending upon how their documents are written.

In some cases, only one credit agency has to cut an insurer’s “AAA” rating to free the dealer from having to buy the debt back. In other instances, the dealer must repurchase the debt unless all three credit agencies cut the insurer.

Some dealers are resorting to highly unusual methods to avoid having to buy back variable rate demand notes.

Ihlefeld said a dealer recently told his firm that it would have to contact the tender agent, who also happened to serve as the trustee, in order to sell some variable rate demand notes.

“That’s pretty unorthodox and it is hampering liquidity,” the Santa Fe-based expert said, adding that in his decade of experience on the bond desk this had never happened.

NEXT SHOE TO DROP?

Lee Epstein, chief executive officer of Money Market One, San Francisco-based institutional dealer, agreed the variable rate demand note market was freezing, at least in spots.

“All I know is, we got a letter saying this stuff is now ‘Best efforts’ for some of these people,” Epstein said, explaining that it was not his role to read each and every document sent his firm.

The term “best efforts” means a dealer will try to help the investor, but is no longer obliged to buy the debt back.

None of this bodes well for the variable rate demand note market. “It’s probably the next shoe to drop,” Epstein said.

Though money market funds cannot own auction-rate paper, they can buy variable-rate demand notes.

After credit agencies last year warned bond insurers to raise capital or risk losing their top ratings, money market funds began selling variable rate demand notes guaranteed by weaker insurers or issued by less credit-worthy borrowers.

Since then, rates these notes pay have gone in two directions, breaking a long-standing pattern.

“Thirty months ago, there was very little variance...from one variable rate demand note to the next,” Ihlefeld said.

But now rates for debt issued by borrowers with high ratings and backed by the strongest insurers have slid to 1 percent or less, the experts said. That is less than half the 2.5 percent rate that had prevailed.

Rates have spiked to 6 percent or even higher for variable rate demand notes sold by weaker borrowers, or debt backed by faltering insurers, the experts said.

A series of spring deadlines could further imperil the market for variable rate demand notes, Epstein said.

Corporations file quarterly taxes on March 15, and many of them might sell these notes to raise cash. Japan’s fiscal year ends on March 31, which is another factor that can cause short-term market fluctuations.

U.S. residents often take cash out of money market funds to pay their taxes by the April 15 deadline.

But another development might shield the variable rate demand note market — a surge in sales by municipal borrowers who are rushing to transform their auction rate debt into either variable rate demand notes or fixed-rate debt.

“It will just re-liquify the market,” said Bruce Whiteford, a managing director at Bessemer Trust in New York.

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