Will Municipal Bond Buyers Be the Next Waive of Injured Investors

This is the latest fall out resulting from Wall Street’s manufacturing and sale of synthetic investment products, CDOs, structured products, proprietary closed end funds, and multi-billion dollar underwritings of the preferred securities of troubled financial institutions.

However, most investors do not understand, nor are their brokers likely to disclose that bonds or fixed income securities, particularly longer term fixed income securities also involve a high degree of risk. As interest rates rise, bond prices decline. Inflation, will sooner or later show up as a result of the government’s irresponsible monetary policy. The government cannot continue to literally print or create money to artificially depress interest rates, pay for wars, stimulate the economy and bailout the countries financial institutions, without causing inflation, the devaluation of the US Dollar, and the increase in nominal and US Dollar denominated interest rates. But for the irresponsible monetary policy by the rest of the industrialized world, which the US has encouraged, the US Dollar would be far worse off in relation to other foreign currencies.

Not only do longer term fixed income securities carry significant interest rate risk, they also also present significant issuer risk.

Those investors that think Municipal Bonds are safe investments, they ought to think again.

According to a recent Time Magazine article:

Municipal Bonds: The Next Financial Land Mine?

As Wall Street nervously watches the sovereign debt crisis unfold in Greece, another potential landmine is looming closer to home, one that could bring U.S. cities and towns to their knees, force the federal government to cough up another bailout package, and potentially send the unemployment rate much higher. The danger this time? Municipal debt.

State and local governments are frantically scrambling to meet budget shortfalls as high unemployment and shaky consumer confidence mean less income tax and smaller sales tax revenue for government coffers. At the same time, falling home prices and rising foreclosures will start to hit municipalities hard this year as all those property reassessments done over the past 18 months kick in.

A couple of municipalities, such as Los Angeles and Detroit, have even whispered the "B" word. Former Los Angeles Mayor Richard Riordan argued in an editorial in the Wall Street Journal earlier this month that the city will likely have little choice but to declare bankruptcy between now and 2014. Also, several smaller markets, such as Harrisburg, Pa., and Jefferson County, Ala., have openly talked about filing for Chapter 9 bankruptcy -- a reorganization available only to municipalities.

In general, municipalities try to avoid Chapter 9 filings. Although such filings make it easier for a city to break onerous labor contracts or make other politically tough cost cuts, they can have hidden costs, such as distracting politicians, alienating business and making it more difficult for a city to raise cash in the capital markets going forward. The city of Vallejo, Calif., for example, has been in Chapter 9 since spring 2008, and observers say the process has been costly and hurt the city's ability to attract new business. It's been two years and the case is still going on and there's still significant disputes with the unions, says Eric Schaffer, a partner at Reed Smith LLP. Ultimately you hope to bring everybody to the table and share the pain, but that can be a messy process.

Bankruptcy is a particularly unnerving prospect for bondholders. Municipal securities are a $2.8 trillion market, according to Municipal Market Advisors. An avalanche of investors sought refuge in the sector in recent years, lured by the stable, tax-free nature of muni bonds. More than $69 billion flowed into long-term municipal bond mutual funds in 2009, up from only $7.8 billion in 2008 and $10.9 billion in 2007, according to the Investment Company Institute. Another $15.2 billion has been added so far in 2010.

But increasingly munis are seen as vulnerable to the same forces that have put companies and some sovereign governments in crisis. The whole system is pretty fragile, says Brian Fraser, a partner at the law firm Richards Kibbe & Orbe LLP. The assumption has always been that municipalities aren't going away and that they can always raise taxes to pay debt, but that's no longer the case, he says. He noted how Jefferson County, which is teetering on bankruptcy, was unable to raise sewer rates to meet its sewer bond obligation. Adds Richard Raphael, executive managing director at Fitch Ratings: This is the worst downturn ... and most pressured environment for municipals in decades.

Some thoughts:

· Note the process at work: The housing bust caused home prices to fall, which over time causes assessments to decline, which results in lower property taxes. This is just now playing out, lowering tax revenues for cities that are already unable to pay their bills.

· Along with U.S. Treasuries, munis are where capital hides during uncertain times. This isn't speculative money; it's "cash" that risk-averse investors assume will hold its value and be readily accessible. So most muni owners aren't paying attention and will be doubly shocked when they not only lose money but can't get at it because of default or bankruptcy.

· This is America's Greek crisis. A major city or state will default on its debts, threatening a cascade failure of the many others in similar straits. The federal government, like the EU, will stare into the abyss and will blink, agreeing to take muni debt onto the federal balance sheet.

· At some point the global markets will notice that the U.S. is just California writ large and will treat the dollar accordingly. Maybe munis are the wake-up call.

The guaranty of municipal bonds by AMBAC and the Federal Government Insurance Co. ("FGIC"), is otherwise meaningless, should these entities become insolvent.

With respect to AMBAC and the FGIC, in a report for the third quarter of 2006, S&P noted that issuers claimed to be tightening their underwriting standards in response to rising delinquencies and early payment defaults. Similarly, Moody’s Investors Service observed that there had not merely been a one-time shift in the quality of loans, but that there appeared to be a trend of weakening loan quality. In the first quarter of 2007, Moody’s noted that "loans securitized in the first, second and third quarters of 2006 have experienced increasingly higher rates of early default than loans securitized in previous quarters."

By mid-2007, AMBAC reported approximately $29 billion of exposure to a total of 28 CDOs. According to the company’s regulatory filings, "AMBAC and the financial guarantee industry faced historic challenges in 2007," resulting from "the global credit market distress, the swift collapse of the subprime mortgage market midway through the year, and the subsequent rating agency downgrades of various mortgage-backed securities, made 2007 the most difficult period in our 37-year history"

In the second quarter of 2007, AMBAC reported losses in excess of $100 million from unrealized mark-to-market losses on credit derivative exposures is the result of unfavorable market pricing of collateralized debt obligations with significant amounts of sub-prime residential mortgage collateral.

Subsequently, AMBAC’s bond insurance unit was put of Rating Watch Negative by Fitch. A review by Fitch of Ambac's exposure to CDOs and residential mortgage-backed securities found that the insurer is roughly $1 billion short of the extra capital it needs.

Similarly, in July 2007, FGIC reported "stress in the U.S. mortgage market," and warned investors of its exposure with respect to its "insured RMBS and ABS CDO transactions."

In the second quarter of 2007, FGIC reported that it anticipated a loss due its insurance liabilities, due to resets in underlying portfolios, and that 93% of resets were attributable to subprime Mortgage backed Securities, and the remainder to Alt-A loans.

For the quarter ended September 30, 2007, FGIC reported net realized and unrealized losses were $206.2 million compared to net realized and unrealized gains of $1.1 million for the quarter ended September 30, 2006. The net realized and unrealized losses for the quarter ended September 30, 2007 were principally due to unrealized mark-to-market losses related to increases in credit spreads on credit derivative contracts issued by the Company, particularly in the CDO of ABS sector.

Subsequently, Moody’s Investors Services, Standard & Poors, and Fitch downgraded FGIC’s rating, and placed FGIC on their respective negative credit watch lists.

Nicholas J. Guiliano, Esquire is a principal of the Guiliano Law Firm, P.C. and his practice is limited to the litigation of securities related matters and the representation of investors in claims against stockbrokers and investment professionals for fraud in connection with the sale of securities, the sale of unsuitable securities, breach of fiduciary duty, and the failure to supervise. Representation is offered on a Contingent Fee Basis. For more information contact the Guiliano Law Firm at (877) SEC-ATTY or visit our Website at www.securitiesarbitrations.com.