As municipal market participants surveyed their surroundings after the worst days of the market's recent history, a robust primary calendar and still uncertain buying conditions have many participants wondering when or whether the market can recover.

On Friday, traders said the market was weaker by as much as 10 basis points in some parts of the curve, based largely on heavy selling by institutional investors like hedge funds, arbitrage accounts, and tender options bond trusts. The huge volume of secondary supply led to a high number of trades.

"There were these huge lists that came out because of changed collateral requirements," said Jon Schotz, chief investment officer at Saybrook Capital.

The Municipal Securities Rulemaking Board reported 61,246 trades Friday of 14,404 separate issues for a total volume of $31.71 billion.

Market sources said at least $3 billion in bonds were being offered for sale Friday, by hedge funds such as 1861 Capital Management, Blue River Asset Management, Duration Capital Management Advisors, and others.

Representatives from these firms did not return calls or e-mails seeking comment.

Funds like these are often leveraged many times. Muni yields have risen since the middle of February, and beginning Feb. 26 corresponding Treasury yields began to move down, creating a decoupling of a degree not seen since August. With the value of muni holdings falling, and Treasury yields going the other way, prime brokers changed the requirements for collateral postings.

Yesterday, 30-year high-grade munis were 115.4% of similarly dated Treasury bonds, down from Friday's high for the year of 116.3%, according to Municipal Market Data.

"Similar to the events of last August, hedged muni buyers saw their hedges unravel as munis became cheaper and cheaper in comparison with Treasuries and [the London Interbank Offered Rate] in recent weeks," wrote George Friedlander, managing director and fixed-income strategist at Citi, in a weekly commentary. "However, it appears that this time, the magnitude of the damage on hedged positions was sufficient to cause a number of hedged investors to experience margin calls."

With Wall Street brokers' capital already stretched thin because of subprime-related write-downs and auction-rate security holdings, the brokers were forced to play a more conservative position.

"In an environment where you have muni prices going down and hedges going up, those brokers had to protect themselves," said Mark McCray, senior vice president and municipal bond portfolio manager at Pimco.

As the brokers changed the requirements, firms were forced to sell into a distressed market, sending yields even higher. The damage was so bad according to market sources, that several fundsmay have collapsed. Market sources also said that traders at several large Wall Street firms, including Citi, worked over the weekend to negotiate the sale of at least one large portfolio.

For the overall market, the selling could not have come at a worse time. This week, the primary market is picking up, with $10.2 billion of bonds set to come to market. Leading the way, the state of California is set to sell $1.8 billion worth of general obligation bonds. In fact, some of the forced selling could have occurred because of the looming primary calendar.

"If you are a seller you are aware of the calendar," and likely trying to sell before the spike in supply, said Bob Nelson, municipal analyst at Municipal Market Data.

In this environment there is some question whether the market will be able to soak up all of the supply.

"Normally the traditional arb account that could come in and buy the paper just isn't there," Nelson said. "Who is left as the buyer of last resort?"

Yesterday, traders said the market was unchanged to slightly weaker, supported by a combination of retail buyers, traditional money managers, municipal bond mutual funds, and more traditional TOB programs. Traders also said taxable crossover buyers were involved, attracted by the muni cheapness relative to Treasuries.

"There's kind of a feeling that any number of participants could support the market but the proof will be in the pudding to see if those people show up," said one trader based in New York. "I think there will be some good participation."

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