The tender-option bond programs that imploded last year did not fall victim to bad luck or unforeseeable illiquidity, a study released last week concluded. Rather, the strategies these programs used were doomed from the start.

Securities Litigation & Consulting Group, an economics consultancy based in Virginia, sought to figure out why more than 35 municipal arbitrage funds marketed by investment banks and asset managers were forced to liquidate this year.

The paper, "Leveraged Municipal Bond Arbitrage: What Went Wrong?" found the funds left themselves vulnerable to minor disconnections in interest rates - the types of fluctuations that happen regularly.

Here is how the programs worked: A fund would borrow money at a short-term rate that reset regularly, and use the borrowed cash to buy long-term munis.

The munis paid a higher, fixed rate than the floating rate paid on the fund's short-term debt. This was designed to turn the difference between long-term and short-term muni rates into a "spread" profit.

For example, on Jan. 5, 2005, a 20-year triple-A rated muni yielded 4.31%, according to Municipal Market Data, while a one-year triple-A yielded 2.07%.

By borrowing at 2.07% and lending at 4.31%, the fund could capture a spread profit of 2.24%.

Because of the risk of the short-term floating rate rising and eating into returns on the long-term munis, the funds tried to lock the rates in. This entailed buying and selling derivatives resulting in the funds collecting a short-term floating rate and paying a fixed long-term rate.

The idea was the short-term rate the funds collected would correlate to the short-term rate the funds paid to their lenders, and the long-term rate paid on the derivatives would correlate to the coupons collected on the munis.

Normally this would result in a fund breaking even. The funds, though, believed they unearthed a fundamental market inefficiency: The spread of long-term muni rates over short-term muni rates is wider than the spread of some other kinds of long-term rates over short-term rates. That is, long-term muni rates are too high.

The supposedly low-risk profit came from the fund collecting a higher coupon on the long-term municipals than it paid on its long-term swap.

The flaw in this strategy, the study concluded, is that for it to work the relationship between the two long-term rates had to stay where it was. The funds failed to grasp how likely the relationship was to change, the study found.

"The correlation was not nearly perfect," according to the study, which was authored by Craig McCann, Sherry Liu, and Geng Deng.

Further, because the funds used so much debt to improve returns, the strategy was "extremely sensitive" to discrepancies in the rates, the study said.

It appears that all it took to knock out half of these funds' asset values was for the difference between the rates the funds paid on their long-term swaps and the rates they collected on their long-term munis to increase by a quarter of a percentage point.

Dislocations of this magnitude happen all the time, the study said. In any given six-month period between 1994 and 2006, there was a 15% chance the spread would increase at least 40 basis points.

Therefore, these funds were using a strategy with a 15% chance of losing more than half their value every six months, the authors concluded.

The lesson, the study said, is the escalation in rates for munis with longer maturities is not an inefficiency. It is compensating investors for taking more credit and liquidity risk.

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