New Monkey, Same Backs

--A new round of higher debt costs confronts some states and cities as another usually humdrum part of the credit markets runs into trouble. This time, the culprits are variable-rate demand notes. And banks that guarantee they will act as buyers of last resort face something they never expected -- having to purchase many of them at once. --Variable-rate demand notes let issuers borrow for long periods -- but at short-term interest rates. Like auction-rate securities, interest payments adjust on a weekly or even daily basis. The difference is that for variable-rate demand notes, securities firms sell the debt at whatever interest rate meets the market's demand. --The problem: Just like many issuers of auction-rate securities whose interest costs soared after auctions for some of their debt failed, an increasing number of municipalities are being hit with sharply higher interest on their variable-rate demand notes because dealers of the debt are having trouble selling it. --Last week, rates on $300 million of California's variable-rate demand notes rose to 8.25% from 2% the previous week. "This is an amazing confluence of problems that no one expected to happen," California Deputy Treasurer Paul Rosenstiel said. --"The entire floating-rate [municipal bond] market is in disarray," said Michael J. Marz, vice chairman at First Southwest Co., a Dallas financial adviser to governments and municipalities. There are about $500 billion of variable-rate demand notes in the market compared with an estimated $330 billion of auction-rate securities --In the auction-rate market, when auctions fail to generate enough bidders, investors are stuck holding investments they can't cash out of. With variable-rate demand notes, securities firms unable to sell the debt -- as has been happening for the past couple of months -- have the right to essentially turn the bonds over to a bank that has guaranteed to buy them. --With limited room on their balance sheets to hold the ballooning inventory of variable-rate demand notes, firms such as Bear Stearns Cos., Lehman Brothers Holdings Inc. and Morgan Stanley have bounced bonds back to "backstop" banks or notified them that they may do so in coming days and weeks if their sales efforts continue to founder. --The largest participants in the backstop business include Bank of America Corp., J.P. Morgan Chase & Co., Citigroup Inc. and State Street Corp. Also, Depfa Bank of Dublin and several other European banks have a sizable presence. --"We as a community can't be warehousing all the risk" of holding inventory of these assets on the balance sheet," said a treasurer at one broker dealer that expects to sell back some bonds to liquidity backstop banks. As the end of the first quarter nears, many firms that once supported the market by buying and holding the notes are being extra cautious and trimming their fixed-income inventories, a municipal-bond banker said. --When the backstop banks buy the bonds, the debt turns into so-called bank bonds. The interest payment rises to the prime rate -- or an amount even higher than the prime rate, now 6%.