How many feet does the damn thing have, anyway? ...In many cases, munis are sold as part of "tender option bond," or "put bond," derivatives. In these programs, which became very popular among hedge funds in this decade because their low risk profiles permitted a lot of leveraging, a bond could be tendered back to the issuer if any of a variety of troublesome events triggered, ranging in severity from a default to a ratings downgrade. The programs required the issuer to buy the bonds back at par, or face value.
If the monoline insurers that guarantee the bonds lose even one notch of their high ratings, then every one of the hundreds of thousands of munis they have underwritten over the years likewise loses its high rating. And that would be an event that could lead bondholders to attempt to tender the bonds back to issuers. Only cities and states don't have anywhere near the tens of billions of dollars it would cost to buy them back. They would need to issue more debt at higher interest rates, and, well, you can see this can spiral way out of control.
Continued: A worst-case scenarios
It's one thing for corporate bonds to run into trouble, because they are typically backed by hefty amounts of assets that can be sold, even if that must happen at rock-bottom prices. And besides, there just aren't that many corporate bonds in the country: If they were all listed in a telephone book, it would be around three-quarters of an inch thick. But there are hundreds of thousands of U.S. muni bonds -- at least enough to fill a 9-inch-thick telephone book -- and cities can't just sell a bridge or sewer line or school building to raise money to pay them off in a crisis.
Let me give you an idea of the magnitude of the worst-case scenario: When ratings agency Moody's put the rating of monoline insurers Ambac and MBIA on downgrade alert last month, it was obligated to, in turn, put about 1,000 structured finance issues -- those CDOs and the like -- on "negative watch," which is a way of telling holders to beware of downgrades of their own. This is exactly what led in turn to banks' headlong efforts to get in front of the crisis by writing down the value of those issues and take multibillion-dollar losses, putting their shares in free falls.
What got less publicity was the fact that Moody's put 60,000 munis on negative watch at the same time for each monoline insurer. And when another ratings agency, Fitch, downgraded a much smaller privately held monoline called Financial Guaranty Insurance, it was forced to put 114,560 municipal bonds on negative watch.
http://articles.moneycentral.msn.com/Investing/SuperModels/TheBigThreatOfMuniDebt.aspx?page=all
