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Subprime Impacts Municipal Bond Market

The ripples from the subprime crisis have reached an unlikely and surprising sector, municipal bonds.  Defaults of subprime mortgages have started a sequence of problems in the credit markets over the past year eventually impacting the municipal bond market (munis).  

Last summer losses in the taxable bond sector and the debt tied to subprime mortgages led to serious write downs. During the last two weeks of February the bond market essentially crashed, resulting in the worst week in the municipal bond market in over a decade. Municipal yields went up about 50 basis points and municipal bond funds declined by anywhere from four to ten percent, which is unheard of over such a short period of time. The media offered little explanation, leaving many investors in the dark. 

In the past bond insurers were capitalized, and the major firms (including MBIA and FGIC) were rated AAA, the highest credit quality. The ratings of the firms are extended to the bonds under guarantee. This caused certain bonds to receive AAA ratings when they should have been investment grade or lower. The higher ratings made it possible for a variety of fiduciaries to own the bonds, and make interest costs lower.  

Potential losses are still unknown, and attempts to recapitalize in order to save their AAA rating are ongoing. But, the damage has been done and bond insurers are being downgraded. According to Bond Buyer, as of April 15, FGIC, once the firm with the strongest capital base, had been downgraded to barely investment grade or slightly below.  

The hesitancy of bond insurers’ ratings parallels the hesitancy of issuers’ underlying ratings. As a result, many bonds are lowering to the underlying ratings, and in some cases even lower.   

Since the downfall first started, there have been signs that the municipal bond market would have serious consequences if bond insurers downgrade, such as the values of munis dropping significantly. These downgrades also have harmful effects on banks’ balance sheets, because some of the corporate debt is owned by major money center banks.  

Munis are relatively new, and gained popularity because the bonds are exempt from federal taxes, as well as city and state taxes if living in the state it’s issued. They also have extremely low default rates and are dominated by the individual investors, who purchase about two-thirds of the bonds.

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