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Muni Market Mixed On 'Bellwether Day'

Following Lehman Brothers Holdings Inc. filing for Chapter 11 bankruptcy protection, and Bank of America's purchase of Merrill Lynch & Co., the municipal market was mixed yesterday, despite the Treasury market showing steep gains in a flight-to-quality bid and tumbling stocks.

"This is a bellwether day, and not in a positive sense," said Richard Ciccarone, a managing director and chief research officer at McDonnell Investment Management LLC. "It opens the door for more problems that might be underneath the surface. And over the years, the financial markets have intertwined themselves with so many new debt instruments that a single failure has implications for many companies, so that seems to have become more intense in recent years."

"If I told people at the beginning of the year that UBS would be out of the muni market, and that Bear Stearns, Lehman, and Merrill would also be gone, they would have had me drug tested," a trader in New Jersey said.

Traders said tax-exempt yields were slightly lower on the short to intermediate end, but weaker by as much as four basis points on the long end.

Amid market turmoil, bond insurer Financial Security Assurance Inc. has temporarily stopped offering its Sure-Bid product to underwriters. The program provides surety bonds that allow underwriters to more easily bid on competitive deals. Through it, FSA pays the good faith deposit if an underwriter that wins a bid fails to, while also saving losing bidders the trouble of withdrawing and redepositing the good faith funds it would have had to post.

"Due to the uncertainty in the dealer community, we are temporarily putting a hold on our Sure-Bid product," said Scott Richbourg, managing director of municipal finance at Financial Security Assurance, in a statement.

In the wake of the Lehman Brothers bankruptcy filing, along with the news of the Merrill Lynch sale, one issue raised has been that of bond deals that had been priced in the primary market by both Lehman and Merrill, but have not yet closed.

"We're not quite clear how that would work. We think it shouldn't be a problem, but again, we're not absolutely sure," a portfolio manager in New York said. "From what I understand, they were going to file at the holding company level, which they thought would make it easier for some of the operating units to trade. This is all still evolving, so that's a very preliminary read."

"You would think on a new-issue transaction, you have buyers on one side with cash, you have issuers on the other side that desire to sell bonds, it should be a fairly easy netting process, but there's no guarantees," the portfolio manager said. "Would somebody else take over? It's still not clear."

"Some of the deals may get scrapped or postponed, or some other lead manager might have to take over," another New York trader said. "I know Lehman didn't have their hands in a lot of the deals, but they were co-managing, so obviously there will be someone to take their place. But some of those deals are going to have to be scrapped and then a new manager is going to have to come in."

"But, the issuers can submit a request and propose that they want a new lead due to market activity or instability, and I'm sure some of them will do it," the trader said. "I sure would. But, again, it's all up to them, so we'll see."

John Sager, chief financial officer of the Idaho Housing and Finance Association, which recently issued $48 million of single-family mortgage bonds on which Lehman was a senior manager, said they "have not heard from them."

"It will have an impact. We're going to have a number of relationships we're going to have to replace," Sager said. "We're in shock."

Tomorrow, Merrill Lynch is slated to price a $250 million Los Angeles deal to refinance debt for the city's convention center. The status of that transaction was unclear yesterday morning, said Natalie Brill, the city's debt management chief.

"We're working it out," she said.

Additionally, Lehman priced a $150 million Puerto Rico Public Buildings Authority deal on Sept. 10 that refinanced variable-rate debt with MBIA Insurance Corp. insurance into fixed-rate bonds. That transaction is set to close on Thursday, yet the Government Development Bank for Puerto Rico, the island's financial adviser, has yet to decide if Lehman Brothers or possibly the deal's co-senior manager, Bank of America, will finish the sale.

"I don't think there's much of a financial issue in terms of the closing because Lehman Brothers was simply the agent for remarketing," said GDB president Jorge Irizarry. "So there's really no impact there, but we have other firms that can step in, if needed, and close the deal."

Michael Pietronico, chief executive officer at Miller Tabak Asset Management, said the Lehman and Merrill news carries "some repercussions for munis," including counterparty risk, and the issue of what happens to gas prepaid bonds that are backed by Lehman.

Moody's Investors Service yesterday downgraded the rating of Main Street Natural Gas Inc. gas project revenue bonds to B3 from A2 following its downgrade of Lehman. The bonds have their rating tied to Lehman, because through a subsidiary it promised to supply gas and also acts as the gas purchase agreement guarantor.

"And in the longer term," he said, "what does the removal of Lehman and the potential removal of Merrill Lynch mean for liquidity, in a market that was liquidity challenged already?"

Pietronico added that the "liquidity dynamics have changed radically, and liquidity is going to be at a premium."

"So larger deals come with bigger concessions, and bigger investors potentially need to make arrangements to trade perhaps in smaller blocks, and try and define where retail demand can move in and out of bonds," he said. "But in terms of [larger blocks], it's going to be very difficult to see those trading actively. I would think most of the trades would be risk-less when you're dealing with very large blocks of bonds, in the sense that the brokers who are left will be just intermediaries, as opposed to just taking on risk."

Additionally, in a weekly report, Matt Fabian, managing director at Municipal Market Advisors, wrote that "Lehman, as was Bear Stearns, has been one of three major market makers, with Citi, in muni high yield paper; their loss will further collapse demand for this sector, which is now at severe risk to price declines on investor redemptions."

Lehman may be forced, at some point, to sell its muni trading, proprietary, and any other inventory," Fabian said. "There is no indication that this is imminent, but fear of such unwinding will loosen muni demand and reduce risk taking across the curve. Further, should asset sales occur, there is no clear buyer for a large amount of paper. Thus, prices may need to be cut substantially, particularly for sub-AA credits."

The Treasury market showed substantial gains yesterday. The yield on the benchmark 10-year Treasury note, which opened at 3.72%, finished at 3.47%. The yield on the two-year note was quoted near the end of the session at 1.78% after opening at 2.21%. The yield on the 30-year Treasury was quoted near the end of the session at 4.12% after opening at 4.32%.

"This is a massive flight-to-quality bid, and I think that's all it is," said Bill Hornbarger, a fixed-income strategist at Wachovia Securities in St. Louis. "People now are worried about anything that doesn't say 'U.S. government guaranteed' on it, so you have Treasury yields rallying significantly. It will end when we get all this behind us. I think right now the market is not as concerned with the economic picture, but it's just people wanting to own the safest securities that they can."

Kevin Giddis, head of fixed-income sales, trading, and research for Morgan Keegan & Co., agreed. "This was flight-to-quality at its highest point," he said.

At today's Federal Open Market Committee meeting, the Fed will look to "establish some confidence and trust," Giddis said. The Fed has provided liquidity with $70 billion in repurchase transactions, including a $50 billion one after the federal funds rate hit more than three times its target rate overnight.

"We're trying to restore confidence and provide liquidity," Giddis said. "They're certainly at a minimum going to a real easing bias, my guess is 25 basis points, in more of a symbolic move, is what the Fed is going to do. And if I saw 50 I wouldn't say anything else like, 'Wow, they've done the wrong thing,' or 'this is a real surprise.' I think at this point the focus is trying to keep the investors and players in this market engaged."

Although the Fed seemed set to hold rates steady at today's FOMC meeting, the market now appears to believe there will be a cut. Last week, options prices on fed futures expected with certainty the Fed would not lower rates, according to the Chicago Board of Trade. Yesterday, the market priced the chance of a cut at a probability of 72%.

Lehman Brothers Special Financing Inc. has a $189.5 million swap with Jefferson County, Ala., which is struggling to avoid becoming the largest municipal bankruptcy by negotiating with creditors to restructure its $3.2 billion of sewer debt. That debt is mostly in auction- and variable-rate securities covered by $5.2 billion of swaps, which the county has been trying to restructure since February.

Jefferson County's four swap counterparties had agreed to forego $250 million in termination payments as part of restructuring plans that were considered but not approved by county and state elected officials. It is unclear if that concession is still on the table now that Alabama Gov. Bob Riley has entered the high-level negotiations.

With Lehman now in bankruptcy, it will be harder for Jefferson County to negotiate a deal and Lehman will be looking to get what it is owed to pay its own creditors, said Peter Shapiro, managing director at Swap Financial Group LLC.

"Lehman has less control over that now," Shapiro said. "It'll be hard to negotiate with Lehman because Lehman can't speak solely for itself."

Further, Lehman Brothers is counterparty on five fixed-to-floating-rate swaptions with the Massachusetts Turnpike Authority. In that agreement, Lehman Brothers pays a fixed rate of 5% and receives a floating SIFMA rate from the authority. The bank also paid a premium of $35.2 million.

The swaptions are attached to roughly $800 million of variable-rate MassPike debt, which the authority anticipates refinancing into fixed-rate debt by the end of the year. MassPike officials yesterday declined to comment about Lehman Brother's bankruptcy announcement and how it could affect the swaption agreement. The authority is currently reviewing underwriter proposals for the upcoming refunding deal.

Depending on how a contract is written, a swap may terminate automatically with the bankruptcy filing or with notice by the municipal issuer. But issuers with the choice are likely to terminate their swaps soon, a lawyer said.

"I think you're going to find counsel advising clients not to wait and see," said Stan Ladner, a partner with Fulbright & Jaworski LLP.

Many of these issuers will owe money on the terminated swaps, since the swaps are now out of the money, Fabian wrote in his report. Although some are wrapped by bond insurers, most will require issuers pay the termination fee.

Also yesterday, state and federal officials took steps toward helping insurer American International Group Inc.

New York Gov. David Paterson announced he had directed the state Insurance Department to allow AIG to borrow from its subsidiaries and raise up to $20 billion to help fund the day-to-day needs of the holding company.

The Wall Street Journal reported later in the day that the Federal Reserve had asked Goldman Sachs Group Inc. and JPMorgan Chase & Co. to provide between $70 billion and $75 billion in loans to AIG.

Michelle Kaske, Rich Saskal, and Shelly Sigo contributed to this story.

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