Risk and Return

Much of what has been happening over the last year in the credit markets was foreseeable, if not assured. I will admit though, I hadn’t really considered this aspect.

A while back MBIA, AMBAC and other monoline insurers backed sleepy municipal bond portfolio’s. Having entered, and then become ensnared, in the broader credit markets, they face being downgraded. If they are downgraded, the bonds they guarantee are downgraded, even money market instruments:

What’s happening is that tax-free money funds are dumping billions worth of muni securities backed by shaky insurers, and these bonds aren’t attracting many buyers. Funds have the right to sell securities back to their brokers. On occasion, doing this is one way muni managers can meet customer redemptions. But now they’re using it as a convenient exit strategy to get out of troubled securities before they’re downgraded.

The problem with that solution:

The Fed worries that banks could wind up stuck with more of these bonds on their books. That would eat up valuable capital reserves. “The Fed wants banks to lend to corporations and personal borrowers, not to act as a holder of last resort,” says Robert Auwaerter, who oversees $440 billion in fixed-income assets, including $48 billion in muni money-market funds, at Vanguard Group. Retail muni money-market funds have assets of $289.5 billion; institutional versions of the funds hold $182.4 billion.

If muni money-market funds keep them they risk losing capital, if they don’t banks already struggling to stay afloat not only have to take on the liability but will have their capital absorbed by these bonds and unavailable to lend to others. The permutations of this crisis are stretching way past my point of imagination.

HT: Abnormal Returns

Technorati Tags banks, Federal Reserve, investing, monoline insurers, municipal money market

Tags: banks, Federal Reserve, investing, monoline insurers, municipal money market

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