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Tabasco and Variable Rate Munis

February 18, 2008

As everyone by now knows, there is chaos in the municipal bond market. This week's Outside the Box is from good friend and Maine fishing buddy David Kotok of Cumberland Advisors (www.cumber.com).

Briefly, he outlines the problems we are seeing in munis, but then he goes on to warn of the possible next shoe to drop in closed end municipal bond funds. David is one of the smarter advisors I know, and when he points out a problem, I would suggest taking action.

Also, as things are getting more dicey in the markets, I may send out more than one issue of Outside the Box in a week when I see something that is worthy of your attention. And remember, we have been through tough markets before, and we always get through them. The key is to make sure you get through them with your capital as intact as possible.

John Mauldin, Editor
Outside the Box

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Tabasco and Variable Rate Munis

The Muni world has been shocked by two types of variable rate dysfunctions. A third one is coming so we will save that until the end of this missive.

Auction Shock.

The first shock came in the auctions of variable rate high grade tax-free municipal bonds. Most notable was the recent auction of the Port of NY & NJ which ultimately cleared at an interest rate near 20%. That's right. The Port paid an annualized rate of 20% to roll a one week reset loan.

Now we all know this is not about default risk. The Port is not a junk bond. This bizarre event occurred because of the capital failure of the usual brokerage and financial market firms who clear these transactions. They simply abandoned the market.

Why did they do this and risk alienating their customers? They may be constrained by capital restrictions because of write-offs they took on other securities. Or they may be choosing to abandon business sectors which are not as profitable as they would like. Or they may be worried about more losses and trying to preserve what is left of their capital. Or they may be required to reduce capital use because of the restrictions of regulators or institutional investors.

Whatever the reasons, they allowed the auction to fail. By doing so they imposed a cost on the Port, which means on the users of the airports and harbor and tunnels. That cost transfers to the taxpayers of NJ and NY. The brokers can no longer be trusted to honor their commitments. The whole of Wall Street knows that. In the longer run this will cost them dearly because of the damage they have done to their clients.

What will happen to the Port? Well it certainly is creditworthy and certainly does not warrant paying 20% to borrow money. Under normal circumstances in normally functioning markets the Port would be paying about 3% in today's interest rate climate. We expect that the notoriety of the failed auction will bring out bidders (from independent firms like us) and the Port's next auction will clear at a dramatically lower rate than 20%.

What if the auction process doesn't unclog? What if we are wrong and the very high rate persists? Well that will be a wonderful return for an investor with the cash to seize this opportunity. We do not think it will last a long time.

The Port would likely bond out this debt into longer term traditional bond structures. Will the Port need a municipal bond insurer to complete that transaction? No. It can certainly do it without a bond insurer; however, the Port will look at the bond insurers to see if the use of insurance can save it money by lowering the net interest cost. This is where the new Buffet or Ross bond insurance companies enter the competition agaisnt the old and discredited MBIA and FGIC and AMBAC. Remember: bond insurance is about reducing cost to the issuers. It is not about replacing the issuer's credit with the insurer's credit.

As we have been repeating in every TV and print media interview, credit enhancement is not credit replacement. The investor MUST look at the underlying credit first. In this case it is the Port and it is certainly a safe investment grade credit.

Floater Shock.

The situation with floating rate municipal notes is a variation on the same theme as auctions. But there are also significant differences. With floaters, there are usually 4 players. The brokerage firms are usually the leading ones because they are the typical vendors of this paper. In the floater case the situation is the same as with the auctions. Brokers are walking away from providing any support. The reasons are the same as with auctions: capital constraints or business line decisions to abandon a sector. The brokers again are taking the risk of alienating clients.

The second player is the bond insurer. Here the downgrade of a Muni bond insurer credit rating triggers actions on some floaters. The terms of each agreement vary. Many of them require maintenance of AAA ratings. So when the bond insurer is downgraded the terms are violated and that allows the broker or credit supporting bank to escape from the transaction. We are seeing some of that activity now.

The third player is the bank who provides a back up credit for the floater. Here the bank has extended a contingency credit line. The bank collected a fee and hoped that there would never be an instance where it would have to use its capital to secure this instrument. Now the broker and the insurer are failing and the bank is worried. It wants to extricate itself from the liability. Usually there are notice periods and other provisions such that the banks cannot do this at once. There are normal cure periods. We are watching these developments now.

The last player in the floater saga is the issuer. As in auctions, it is the issuer that has to pay if the rate on the floater spikes higher. We are now seeing many solid and stand alone A credit rated issuers paying 7% and 8% on their floaters. Like the Port in the case study above, they are determining what actions to take. No airport, or sewer authority or hospital wants to continue to pay this high a cost for financing. They, too, have the option of bonding out to a traditional structure or of substituting a new AAA insurer for their existing one. The may fire their present broker/underwriter for failing to support their issue. Remember: these brokers make money by selling bonds for the issuers. Part of that relationship is based on trust and support. The brokers have now breached their implied (not legally binding) commitment. There is trouble coming in this business line.

Closed end funds and their preferreds.

This is the next "shoe to drop." Closed end funds are often leveraged. A sponsor assembled a pool of Munis and then added a variable rate preferred to it. The leverage between the Munis and the preferred was often 2-to-1 or even 3-to-1. The preferred would be sold through brokers as a substitute for a money market type liquidity instrument. The rest would be packaged into a closed end fund and the broker would peddle that to retail clients.

Because of the leverage, the retail client was offered a tax free income higher than he might obtain by buying a bond directly. Often the bonds were all insured so that the broker was selling a product that was labeled AAA.

Well the AAA is now distrusted or downgraded. And the preferreds are not easily reset by an auction provision. In other words the preferred pay their variable rate based on a formula that was outlined in the prospectus at the time of issuance. Here is where it gets sticky.

The broker has no legal obligation to maintain a market in these preferreds. He has been doing so as a convenience to his clients and as a way to facilitate the sales of the closed end funds. Now that things are in disarray, the broker does not want to commit capital to support this security. So he is letting it go. He has no legal obligation to maintain a market even though he has a tradition of doing so for many years.

The sponsor of the closed end fund has no legal obligation to pay a variable rate higher than that which is set forth in the prospectus. Why should he do so? He has been paid and the he is collecting his fees regardless of the market price of this security.

All this points to more possible pressure on closed end municipal bond funds. The preferreds will certainly be marked down substantially if they are trading in a market system. The impact will be to cause suspicion about the closed end fund net asset value. At the same time the formerly AAA rated bonds are losing their apparent safety as the Muni bond insurers are downgraded. That may cause the market prices of those bond funds to fall. Some already have done so.

Investors in closed end bond funds tend to be passive. And the fund is also passive. So they may not realize this shift in value until after some of these investors notice the price change in their broker's security account. They may not see this until the month end.

What happens when retail investors suddenly see a large drop in the value of a security they thought was AAA and very safe? Time will soon reveal this outcome. And what happens to the customers of the brokerage firms who were counting on the liquidity provider (their broker) to redeem these variable rate instruments at par so they could use the cash for payments. We expect this to be a mess.

The mess will be exacerbated because the instruments are passive in nature. There is no bank back up letter of credit. And the leverage was originally deemed to be quite safe so there is no bond insurer protecting the owner of the close end fund. The bond insurance was on the bonds in the fund and not on the fund shares directly.

What should an investor do?

First: you must examine the underlying credit and structure. At Cumberland, we have continuously advocated the need to do the homework. We will repeat the mantra: CREDIT ENHANCEMENT IS NOT CREDIT REPLACEMENT.

Secondly, if you own these securities and if you have done the homework, do not panic. We are holding issues in selected accounts and where we have reviewed the structure. They are bargains. If the underlying credit of the issuer is sound, you will be able to work this out because the issuer will see to it. Issuers are answerable to state and local governments and must account for their actions.

Thirdly, the picture is mixed for closed end funds. There is no party invested in curing things. That means it will take market action to clear this sector. We believe that a tremendous buying opportunity may evolve in the closed end sector if it starts to get hammered by selling. We are already seeing signs of emotionally driven sales. We have watched investors panic and liquidate securities without fully understanding the outcome. That panic momentum is evolving. We hold a few selected closed end funds which meet our review criteria. We expect to buy more if the prices fall and deliver bargains to us.

In our view, panic and dysfunctional markets create opportunity. We are seizing it. Some variable rate securities are now trading at double and triple their normalized yields. The Port at 20% is a prime example of unsustainable dysfunction. That interest rate is an unsustainable rate for the Port to pay and for the investor to collect. The same is true of many smaller issues. We are buying them.

Lastly, in times like these one needs to be calm and to have an iron stomach. I have written this in the past. The best bargains are obtained when the markets are in disarray. When the thought of buying a security makes you sick, that is likely to be near the bottom. Folks: we are very close. Bring on the Tabasco.

Conclusion

Your preferring salsa to Tabasco analyst,

John Mauldin

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