WASHINGTON — Despite recent headlines warning that deteriorating state and local finances will lead to bond defaults, a Treasury Department advisory committee has determined the municipal market “appears to be in reasonably good condition.”

The Treasury Borrowing Advisory Committee, which was charged with conducting an examination of the muni market, disclosed its finding in an Aug. 3 report to Treasury Secretary Timothy Geithner.

“Broadly, municipalities still have a low probability of default, historically high recoveries, low absolute cost of funds, access to a broader investor base via the Build America Bonds program, and a largely unlevered existing retail investor base,” the committee said in the report.

“Implicit in this analysis is the federal government’s willingness to intervene in the event the municipal market ceases to function,” it added without further explanation.

The 13 committee members, which include bankers and fund managers, meet quarterly to advise the Treasury on bond yields and how much debt to issue. The committee also periodically analyzes other financial markets, but a spokesman stressed that the analyses do not represent the views of the department. Ten of the members either declined to comment or could not be reached for comment on the report.

At the Aug. 3 meeting, which included Treasury and Federal Reserve officials, the unidentified committee member who made the presentation on the muni market said issuers face two major risks: market access and new-issue pricing. In terms of market access, the member noted that a state general obligation default “seems unlikely,” but if one occurred, “it would result in significant dislocation in the new issuance market,” according to the minutes of the meeting.

“However, this risk is mitigated by a number of factors, including: state taxing authority, low debt/gross domestic product ratios, low debt-servicing costs, high debt payment priority, expense reductions, alternate sources of funding (asset sales, revenue stream securitizations), as well as rainy-day reserve funds,” the member said.

On new-issue pricing, the member suggested that muni issuers would likely face higher financing costs if the BAB program is not extended.

Other concerns include worsening credit quality of issuers and regulatory reform measures, which could affect banks providing letters of credit for variable-rate issues, the member said.

Life insurance companies are the largest BAB purchasers, owning more than 50% of the market, he said.

The committee member also addressed municipal credit default swaps, saying that market “is small and relatively illiquid.” Five states — California, Illinois, New Jersey, Florida, and Texas — have actively traded CDS.

In the last week of July, only $105 million of single-name municipal credit default swaps were traded, compared with $144 billion in other types of CDS, the member pointed out.

The Markit MCDX index, which contains 50 equally weighted state and local government issuers, “is a poor indicator of perceived risk in the municipal market, given that it is subject to inconsistent market making and unpredictable investor participation,” the committee member said. The MCDX, which launched in May 2008, has about $3.8 billion of net notional value outstanding, significantly below the $300 billion for the investment-grade corporate index, the member said.

Otis Casey 3rd, vice president of credit products for Markit Group Ltd., said the MCDX “is simply one barometer of the credit risk on a subset of issuers in the municipal market.”

The index has seen “a gradual increase in interest but it is still a fairly new market,” he added.

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