Money-losing banks might sell U.S. municipal bonds

This could prompt them to sell billions of dollars of municipal bonds that they now have salted away in tender option bond programs, sometimes as part of their capital.

"Banks that built up tender option bond programs as part of managing their tax liability now have losses," explained Evan Rourke, a portfolio manager at M.D. Sass in New York.

"There's no need to have that (tax advantage) at this point and they might end up selling those portfolios," he added.

Many big banks used tender option bond programs, which buy long-term municipal bonds and pay for them with low-cost short-term notes.

But short-term rates spiked in February, partly due to concerns about whether bond insurers were still credit-worthy. This increased borrowing costs for many issuers, prompting them to start switching to fixed-rate debt from floating-rate debt.

Fears of this coming supply deluge pummeled the long-term tax-free bond market, sending yields soaring at one point to 30 percent above what Treasuries offered -- though investors must pay taxes on T-bonds.

As a result, tender option bond programs got slammed as both short-term and long-term yields turned against them.

One company that now might not need tax-free income, because it will be able to take advantage of tax loss carryforwards, is Bear Stearns & Co (BSR.P: Quote, Profile, Research), which also had a tender option bond program, market sources said. A spokeswoman for Bear, which suffered heavy mortgage market losses last year, declined comment.

Bear Stearns, in its 2007 annual report, said that it created a tender option bond program in 1997.

"In the Company's capacity as liquidity provider to the trusts, the maximum exposure to loss at November 30, 2007 was approximately $3.87 billion, which represents the outstanding amount of all trust certificates," it said.

"This exposure to loss is mitigated by the underlying municipal bonds held by trusts," Bear said, noting the bonds were either "AAA-" or "AA-" rated, insured or escrowed to maturity. Those bonds "had a market value, net of related offsetting positions, approximating $3.77 billion at November 30, 2007," it added.

(Reporting by Joan Gralla and Anastasija Johnson; Editing by Diane Craft)