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Mortgage crisis fallout spreads to 'muni market'

Investors are wary of insurance guarantees for some bonds issued by cities to fund capital projects.

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Part of the problem is that investors still don't know the extent of the losses in the subprime mortgage mess. Financial institutions continue to write down loans. On Tuesday, for example, Fitch Ratings said it was reworking its computer models on losses in the CDO market.

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"Fitch believes that a sharp increase in expected losses would be especially problematic for the ratings of financial guarantors," Fitch said in a statement.

Without good information, "the market is pricing in pretty bad scenarios," says Mr. Stone. "The worst case is if the structured debt defaults and the insurance companies don't have the ability to pay."

Municipal bond funds are trying to appease investors who have been withdrawing funds and moving into Treasury securities. "There is a mini-panic out there," says Bob MacIntosh, who runs a municipal bond portfolio at Eaton Vance in Boston. "I have never seen anything like it in my 25 years in the business."

Investors are conjuring up defaults everywhere, Mr. MacIntosh says. But, he says, "All issuers are paying their debt service."

The lack of appetite for the bonds is especially acute for short-term muni securities, which have about a one-week maturity. They would normally be purchased by tax-exempt money-market funds.

Some of the blocks of bonds are insured by Ambac or FGIC. The money-market funds are returning those investments to the underwriters, such as Merrill Lynch and Citigroup, which are subsequently losing money on the deal. "If the auction fails or there is a high interest rate, the banks are losing money on their position," says John Mousseau, who heads Cumberland Advisors' tax-exempt fixed-income area.

Some investors are considering getting into the business. Warren Buffett has said Berkshire Hathaway, his investment vehicle, will enter. Vulture investor Wilbur Ross has also said he's looking at the business. And a consortium of eight banks, including Citigroup, has indicated it is looking at beefing up Ambac's capital.

Stone says the flight to safety is causing his analysts to look at the underlying rating of the bond, not just the rating of the insurance company. For some issuers, this shift has been beneficial. For example, the state of Wisconsin sold $127 million in water and sewage bonds last Thursday. It carried no insurance, even though the bond was rated AA+, not quite the highest rating. "It was sold at a record-low interest rate," says Frank Hoadley, the capital finance director for Wisconsin. "As far as I know, there are willing investors out there."

However, some communities have had to adapt. Miami-Dade County, after shelving a $540 million bond refinancing in November for construction at Miami International Airport, went to a $411 million offering in December. Miami officials did not return calls for comment.