Though Moody’s Investors Service says its possible downgrades of banks may have substantial impact on variable-rate demand bonds, outside experts are skeptical of this.

VRDBs are long-term securities with short-term interest rates because investors can withdraw their money with little notice. Banks guarantee the VRDBs.

“Investors, including money market funds, purchase these obligations based largely on the credit of the bank providing support,” Moody’s explained in a press release Wednesday. The release was for a report Moody’s also released on Wednesday, “Bank Credit Pressures and Regulatory Changes Challenge the Market for Variable-Rate Demand Bonds.”

In February, Moody’s started a review for a downgrade on 17 banks and securities firms, including Bank of America.

Bank of America provides credit support for $35 billion of the short-term municipal credits that Moody’s rates, said Thomas Jacobs, senior Moody’s credit officer. This makes it the second-largest credit provider for short-term muni credits rated by Moody’s, behind JPMorgan.

Money market funds generally invest in credits rated at what is called the “tier 1” level. Moody’s has threatened to lower the Bank of America operating company from its tier 1 P-1 rating to a sub-tier 1 rating.

“If the reviews ultimately result in a contraction in the universe of P-1-rated support providers, we may see rotation by money market funds out of affected VRDBs and similar bank supported obligations,” Jacobs said. “It could also result in a spike in reset rates, increased incidence of failed remarketings, and difficulty arranging replacements and extensions of support, particularly for weaker credits.”

“In 2011, many [municipal] issuers replaced variable-rate demand debt with variable-rate bank loans. Moody’s expects issuers would rely even more heavily on direct loans and other structures not reliant on credit and liquidity support from banks in the event of a contraction of the P-1 rated universe of support providers.”

However, several outside experts disagreed with Moody’s predictions about what would happen if there are bank downgrades.

Securities and Exchange Commission Rule 2a-7 says that the determination of whether a VRDB should be considered tier 1 is based on the top two ratings of the letter-of-credit provider, said Stephen Keen, counsel at Reed Smith LLP.

For example, if Moody’s downgraded Bank of America to P-2 from P-1, money market funds could still consider the bank’s supported VRDBs as tier 1. This is because Standard and Poor’s gives the Bank of America operating company a rating of A-1 and Fitch Ratings gives it an F1 rating. Both of these ratings are considered tier 1 ratings, Keen said.

Bank of America declined to comment for this story.

“I believe most investors will continue to purchase the [securities] because of their first-tier status under rule 2a-7,” said Mary Jo Ochson, chief investment officer of municipal money market funds at Federated Investors. In the aftermath of Moody’s downgrades of banks, a few tax-free money market fund directors might cut use of the affected banks, but most would not, she said. A Moody’s downgrade of banks would largely be a “nonevent.”

“There is far more demand for variable-rate demand notes than supply of these instruments,” Ochson said.

“We’ve seen worse,” said Peter Crane, president of Crane’s Data, which observes the money market industry, about the possible downgrades. “The market is getting used to these fire drills and should adapt in short order. Ratings are not as predominant on the tax-exempt side of the money fund business, so some funds may be able to continue considering much of the supply 'first tier’ even with a Moody’s downgrade. Taxable money funds are also rotating out of the sector as yields rise in their primary marketplace, so the pending reduction in supply comes at a good time. As we saw during the downgrades of the municipal guarantors in 2008, the VRDN market should be able to adjust without too many gyrations. … Spikes in rates too are rare indeed. The market is so starved for yield that any uptick is met with withering resistance.”

Asked to respond to these observers’ skepticism of the report, a Moody’s spokesman, writing on behalf of the report’s authors, quoted from the report: “It is uncertain how widespread tenders of debt backed by any major support providers will be, as money market funds will be influenced by a number of considerations. Factors that will affect this outcome include individual funds’s interpretations of Rule 2a-7, diversification policies, tolerance for risk, and internal guidelines with respect to holdings of obligations supported by P-2 rated banks.”

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