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Fifty-three state and local municipal housing finance agencies were warned by Moody's this week that $4.1 billion of such agency bonds, which mostly finance low- and moderate-income housing, could be downgraded. But the problem is deeper than that and has the possibility to turn into major losses.

Here is what happened. Housing agencies and other municipalities sold bonds to raise funds for various projects. These funds were in turn invested in long term guaranteed investment contracts or GICS issued by the now troubled Pallas Capital Corp. The contracts were to pay between 3% to 5% annually.

In all, Pallas Capital issued more than $614 million in guaranteed investment contracts to 53 state and local municipalities, according to Moody's. Pallas was suppose to reinvest the proceeds into safe interest bearing instruments but instead invested into reverse repurchase agreements with their troubled parent, Depfa Bank. Moody’s downgraded Pallas GICs because “the GICs are a direct pass-through rating of the reverse repo counter party, DEPFA Bank,” who was recently downgraded on its own ability to pay back short term loans.

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This is a potential mess for a few reasons. First this doesn't smell like an arms-length transaction. Pallas could have transacted with large institutional players like JP Morgan (JPM) or Goldman Sachs (GS). Second, Depfa Bank has been in trouble with municipalities since 2008 when it sold hundreds of millions in money losing investments to the State of Wisconsin’s school districts and New York’s Metropolitan Transportation Authority. Third, Depfa Bank’s other losses have dragged down its own parent, the Hypo Real Estate group.

Who are the casualties?

The major potential casualty so far is Ohio's Housing Finance Agency, which now has $3 billion of its bonds at risk for ratings cuts and had $43 million with Pallas as of September 30.

So how does this potentially affect closed end fund investors? There are two single state closed end funds with a relatively high exposure (11%) to various Ohio Housing Finance Agency bonds.

  1. Van Kampen’s (VOQ), “Ohio Quality Municipal Trust” holds 11.9%
  2. Eaton Vance Ohio Municipal Income Trust (EVO) holds 11.5%.

This is too highly concentrated a position for a triple-tax-free single state municipal fund. After all, these funds have limited methods available to achieve reasonable diversification levels to lower portfolio risk. The main technique is to cap the percentage holdings of any one issuer to 2% or less. This is a basic portfolio management concept that even retail bond investors know about.

How could this all play out?

The potential fallout appears similar to other blow ups like the 2008 auction rate security market. Many professional investors placed billions into such investments only to see dividend payments suspended, liquidity dry up and in some cases a complete loss.

It wasn't until a few weeks into the auction rate security mess that investors and markets realized the troubling illiquidity effect of not having access to what was supposed to be cash-like investments.

The question is, why did Ohio and other municipal investment trustees over allocate into guaranteed investment contracts? Are some municipalities so incapable of basic cash management that their actions indirectly cause financial downgrades? It is troubling that what would appear to be a non material event, which spread across 53 states, could potentially cause ratings downgrades and potential losses. Are state cash flows so tight that downgrades occur when an average $465,000 debit may or may not be paid on time? Or is there more to this?

A run on the bank

The real problem could be the mass redemptions that could bankrupt Pallas Capital overnight. Markets have seen implosions of Lehman and others who faced similar redemption. While GICS are generally long term investments, Moody’s downgrade of Pallas does allow states to elect to liquidate early thereby forcing Pallas to return all invested monies. Whether Pallas, or its parent Depfa, can sustain this kind of mass redemption remains to be seen. Pallas is in the process of raising cash by unwinding its own existing investments which include $510.4 million of repurchase agreements with Depfa Bank (rated BBB). If a bankruptcy occurs there will be problems for all states since a bankruptcy court would likely claw back all disbursements made in the last 6-12 months. Just like was done with the Bernie Madoff scandal and bankruptcy.

If Pallas can't liquidate fast enough then states may need to dip into their reserve rainy day funds to pay short term expenses. Using these reserve funds automatically triggers a material event filing and a likely ratings downgrade which issuers are desperate to avoid since it makes all new bond issuance and loans more expensive.

How are bond investors reacting to all this? Here is a representative Ohio Housing Finance Agency bond trading at a 30% discount to par, yet yield is considered expensive.

Disclosure: No positions

Source: Muni Bond Housing Downgrades Coming to a State Near You