By Michael Connor - Analysis
MIAMI (Reuters) - The collapse of one Wall Street firm and the merger of another over the weekend may raise Main Street America's borrowing costs as those investment banks are central to the trading of the municipal debt that finances schools, parks, hospitals and roads across the nation.
The bankruptcy filing by Lehman Brothers Holdings Inc (LEH.N: Quote, Profile,Research, Stock Buzz), the No. 3 underwriter for competitive deals in the $2.6 trillion tax-free municipal debt market, and the $50 billion acquisition of Merrill Lynch & Co Inc (MER.N: Quote,Profile, Research, Stock Buzz), will also restrict liquidity in the municipal bond market, according to traders, portfolio managers and investment strategists.
Indeed, on Monday, the first day of trading after the historic developments on Wall Street this weekend, U.S. municipal bond transactions were few and overall trading slow.
"People are very leery of jumping in," said a Midwest municipals trader. "You are losing two large issuers, two large sources of liquidity. People are sitting and watching."
Higher costs for cities, school districts and other public borrowers will show first in wider spreads between what investors are willing to bid for bonds and the offering prices sellers demand, according to portfolio manager and Vice President Evan Rourke at M.D.Sass Associates in New York.
"From our point of view, it just means we'll look for more spread ourselves," Rourke said, adding the drop in liquidity will raise expenses for tax-free issuers.
Rourke said he could see bid-ask spreads, or the difference in debt prices as expressed in interest rates, topping forecasts of a widening between 10 to 15 basis points.
"I could definitely see it getting wider," he said. "You just have fewer people who are capable of stepping up."
CREDIT CRUNCH HITS HOME
The purchase of Merrill Lynch, a firm capable of buying sizable primary offerings for sale through its massive retail network, by Bank of America (BAC.N: Quote, Profile, Research, Stock Buzz) and the bankruptcy of Lehman were just the latest casualties among major municipal players.
Within the last six months, two other major dealers stepped back from the municipal market. Bear Stearns & Co. was acquired by JPMorgan Chase & Co (JPM.N:Quote, Profile, Research, Stock Buzz) and UBS Securities (UBSN.VX: Quote, Profile,Research, Stock Buzz) disbanded most of its municipal operations in June.
"One result of all of this has been a continued reduction in amount of balance sheet assets available to the muni market," Citigroup Global Markets Inc analyst George Friedlander said in a note written on Friday. "Another is a reduction in the number of participants available to bid on new underwritings or blocks of bonds in the secondary market."
Liquidity, or the ability to turn an asset into cash, has already been hurt by the exit of Bear Stearns and UBS and worries about other big institutions in the municipal market, according to Friedlander.
Bid-offer spreads on bond blocks of $20 million or more and those under $2 million have widened and grown more volatile in recent weeks, because of shifts in demand, according to Friedlander. Bonds with unusual coupons or structures are proving harder to sell because of deteriorating liquidity.
Smaller and regional firms have grown more active in municipals during recent months, but may not be able to pick up all the slack, traders and portfolio managers have said.
Some hard-pressed local governments and other issuers will postpone borrowing, according to Matt Fabian, analyst at Municipal Market Advisors in Concord, Massachusetts, who cut his forecast for new municipal debt for 2008 to $425 billion from an earlier forecast of $450 billion.
"This may translate into ratings or even credit issues for some governments that have planned on selling bonds to patch current year budget gaps," Fabian said in a weekly commentary. "Further, the deferral of needed infrastructure, replacement and maintenance will increase future costs while slowing economic growth; this puts more pressure on tax rates and political infrastructure going forward."
In Monday's municipal trading, morning volume was just 40 percent of the average of the last 30 days, according to MMD Trade Tracker.
Following sharp increases in US Treasuries bid up by investors fleeing equities, muni prices ramped up enough on Monday to reduce yields by as much as 3 basis points to 7 basis points in long maturities, according to Municipal Market Data.
(Additional reporting by Joan Gralla in New York)
