Liquidity in the short-term market has dried up to the point where "there's pretty much a total lack" of banks willing to provide issuers with letters of credit or standby bond purchase facilities, the executive director of the Municipal Securities Rulemaking Board said yesterday.

Speaking at an Investment Company Institute conference in midtown Manhattan, Lynnette Hotchkiss said that the cost of liquidity facilities - which are purchased for some short-term instruments like variable-rate demand obligations - has become "prohibitive" for many issuers.

She added that in instances where issuers have found a liquidity provider, the terms of the agreements are significantly different than in previous years.

"If you can find someone and you can afford the terms of those agreements, what used to be five years for a standard term, you can barely get a one-year term now," Hotchkiss said, speaking at ICI's Equity, Fixed-Income, and Derivatives Markets Conference. "So that's having a real, significant impact on municipal issuers."

Turmoil in the large but opaque VRDO markets comes about seven months after the upheaval in the auction-rate securities market. The ARS market collapsed in mid-February when firms that historically supported the auctions of the securities, but were under no contractual obligation to do so, stopped propping them up. Since then, many issuers converted their ARS into VRDOs with five-year put options.

But amid the ongoing financial crisis, spooked investors last month overwhelmed several remarketing agents with requests to tender their VRDO holdings. As a result, the agents were forced to either increase the rates on the securities or put the VRDOs to the banks that provided liquidity facilities on the securities.

Constrained by balance sheet limitations, remarketing agents either were unable to carry - or had great difficulty in carrying - the securities on their books, as were many of the banks that have liquidity agreements.

The reluctance of financial firms to carry VRDOs is evident in the spike in the weekly Securities Industry and Financial Markets Association's municipal swap index, which is based on VRDO yields and spiked from 1.79% on Sept. 10 to 7.96% during the last week of the month. It has since declined somewhat to 5.74%.

Noting that California Gov. Arnold Schwarzenegger informed the Treasury Department last week that his state is temporarily unable to borrow in the short-term markets and may ask for a federal loan, Hotchkiss said the governor's thinking "makes sense when short-term rates are so significantly higher than issuers have recently enjoyed."

The MSRB is developing a system that will boost the transparency of the VRDO and auction-rate securities markets and should help those markets, Hotchkiss said. The system, which will launch in three phases beginning in the first quarter of 2009, will collect and disseminate 10 to 12 data points for ARS and VRDOs, including reset and maximum rate information.

The system will feature data on individual auctions or remarketings, such as the number of bidders, and will also warehouse liquidity facility documents for VRDOs and program documents for ARS that describe auction procedures and how interest rates are determined.

Hotchkiss told those at the ICI conference that the MSRB is acting rapidly to implement the system. The board has said the first phase of the system will include interest rate information for both VRDO and ARS products as well as ARS documents. Later phases will include VRDO documents.

Though the short-term market disruptions present pressing problems to many issuers, market participants have noted that regulatory agencies like the MSRB have to go through procedural hoops and can rarely implement new rules quickly. Any MSRB proposal is subject to public comment after which a finalized rule proposal must be sent to the Securities and Exchange Commission, where it is subject to another round of comment before approval and implementation.

In opening remarks at the conference, Paul Schott Stevens, ICI's president and chief executive officer, said that free and liquid trading in money market funds has been sorely tested in recent weeks, forever altering the landscape of the money market.

"We are prepared to engage in a thorough examination of how the money market can function better, and how all funds operating in that market should be regulated," he said.

During the week of Sept. 15 - when Lehman Brothers Holdings Co. filed for bankruptcy and American International Group teetered on the brink - the assets in institutional prime money market funds fell by $239 billion as a wave of redemptions swept over the funds, in part because of a flight to safety in which funds began investing solely in government paper.

The redemptions picked up after the Reserve Primary Fund, which had $62 billion in taxable assets as of June 30, announced following Lehman's bankruptcy filing that it had suffered heavy losses from investments tied to Lehman and that it could not pay $1.00 per share and would therefore "break the buck."

That event, rather than any lobbying from ICI or the money market industry, prompted the Treasury Department to unveil $50 billion of guarantees to cover assets that were in money market funds at the end of Sept. 19, using its existing Exchange Stabilization Fund, which consists of U.S. dollars and foreign currencies. Stevens reminded funds that they only have until Oct. 8 to enroll in the guaranty program.

He also told the conference: "Money market mutual funds did not ask for federal insurance for our product. We nonetheless welcomed the guarantee program, because Secretary [Henry] Paulson regarded it as essential to get ahead of the unfolding crisis by bolstering confidence in money funds and preserving those funds' crucial role in the economy."

Schott dismissed concerns expressed by the banking industry that the money fund guarantee was "devised as a means of sweeping deposits out of [bank] vaults." He said the banking industry wrongly claimed of the "victory they scored" when Treasury announced that the guarantee would be limited to the amounts that investors held in participating funds as of Sept. 19.

"The real story is this: it was ICI that proposed the Sept. 19 cap," he said. "We did so to remove any opportunities for arbitrage and to prevent further disruptions to the financial system. Protecting investors, not securing competitive advantage, was our sole focus."

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