Bloomberg details:

An extension of the U.S. Build America Bond program was left out of a compromise that President Barack Obama struck with congressional leaders to prolong tax cuts enacted in 2001 and 2003, White House officials said.

Concern that the program would lapse has weighed on the tax-exempt bond market since an end to Build America issuance may boost the amount of money state and local governments borrow with tax-exempt debt. Issuers have also rushed to sell Build America securities before year-end.

Just weeks before the Build America Bonds program is set to expire, issuance and demand for the government-subsidized notes have reached a fever pitch.

Pricing pressure from a glut in supply, uncertainty over changes in the government’s subsidy levels, and a spike in the Treasury’s 30-Year bond—to which municipal notes are typically pegged—have pushed yields higher, according to investors.

Some investors and analysts say this may be the sweet spot for buying the Build America Bonds, which are now the fastest-growing part of the $3 trillion municipal debt market. “We think we’re at the high for yields,” says one muni bond investor. “If you’re going to buy, now is the time.”

Housing downturn in the epicenter of the subprime fiasco = high unemployment (per The Big Picture):

“California continues to bleed jobs, more so than most of the rest of the country. The national unemployment rate for May was 9.4%, and only four states had higher jobless numbers than California: Michigan at 14.1%, Oregon at 12.4% and Rhode Island and South Carolina, tied at 12.1%.

The state of California is facing a multi-notch downgrade of its debt if it fails to resolve its budget woes, Moody’s Investors Service said Friday.

The warning follows a similar one from Standard & Poor’s, which put the state on a negative credit watch earlier this week because of its dismal financial condition.

“If the legislature does not take action quickly, the state’s cash situation will deteriorate to the point where the controller will have to delay most non-priority payments in July,” Moody’s said. “Lack of action could result in a multi-notch downgrade.”

There's still very low default risk in owning California bonds. California still has enormous amounts of structural protection for bond holders. But that being said, situations where the voters gave, depending on your interpretation, but a fairly clear message, I think, that tax increases are off the table. So it should have been able to reduce the polarization of that legislature and facilitate a quicker budget solution, but it just has not been the case. It's almost been the opposite. Now the legislature seems to not know what to do at all. The Governor has taken two-year cash flow borrowing off the table for this year, which means that really the focus has to be even more on cost cutting.

Reuters reports:

Ahead of a major bond sale next week by California, Fitch Ratings on Thursday cut its "A+" rating on $47.4 billion of state general obligation debt to "A" with a stable outlook, citing falling revenues and the weak economy in the most populous U.S. state.

Fitch analysts in a report noted California's "economic performance and revenue expectations have continued to decline since the state developed its current revenue forecast in November 2008," and pointed to a state unemployment rate of 10.1 percent and a recent state legislative analyst's warning of a "sizable" revenue shortfall in the next fiscal year.

Now for what seems like my weekly California update:

Housing continues to deteriorate (per Bloomberg):

California home prices plunged 42 percent in December from a year earlier as the U.S. housing slump deepened and foreclosures hit record levels.

The median price for a single-family home in the most populous U.S. state dropped to $281,100 from $480,820 a year earlier, the Los Angeles-based California Association of Realtors said today in a statement.

Foreclosed properties tend to sell at a discount of 25 percent or more, and California home sales rose 85 percent in response to last month's drop in prices, the Realtors association said.

This is a recycling of a previous post, which again becomes relevant given the new issues facing California. CNN reports:

The check isn't in the mail, and it's not going to be for at least 30 days, California will start telling some of its creditors in February.

The state, facing a $42 billion deficit, will delay some crucial payments to stay liquid, state Controller John Chiang announced Friday.

Among those who will be left waiting for checks are thousands of businesses that provide services and products to the state; more than 1 million aged and disabled Californians who need to pay for rent, utilities or food; and individuals and businesses awaiting tax refunds to the tune of $1.91 billion.

They asked the California state treasurer Bill Lockyer whether the California public debt was completely safe. “Absolutely, the only way we’re going to default is if there’s a thermonuclear war.”

So there’s no doubt that California will pay back the debt. In the worst case, the Federal Reserve would just bail the state out. If they’re willing to bail out car companies, I’m sure they’ll step in for California.

But if there’s more bad news, the yields could go higher still, and the prices of the bonds could fall in value.

The Bond Tangent points to a Bloomberg piece declaring California Muni Bonds are priced for trouble:

“The spreads have widened and investors are getting much more compensation for California bonds,” said Paul Brennan, who oversees about $12 billion in municipal-bond funds for Nuveen Asset Management in Chicago. “There’s still a lot of ups and downs to come unless there’s some dramatic budget agreement that could change all that.”

The nation’s most-populous state will run out of money to pay bills as soon as February unless lawmakers end an impasse over how to close the funding gap. California has the second- lowest credit ratings in the country because of perennial fiscal shortfalls and legislative gridlock.

It is not difficult for me to see more smaller government entities going bankrupt. But one of the world's largest economies? People really need to get a handle on what this would mean.

Great recap of the Muni market and its anomalies over at The Bond Tangent. One story he posts to from The Bond Buyer:

discusses some anomalies that have emerged since institutional investors largely exited the market and munis became less liquid, including 1) prerefunded bonds yielding higher rates than the Treasuries they are backed by, 2) corporate-backed munis trading cheaper than the corporation's taxable debt, and 3) insured bonds trading cheaper than bonds of the same underlying credit quality.

We detailed a few weeks back why Muni's were a screaming buy. Here's the proof.

Hedge funds have been forced to unwind a tremendous portion of their Municipal Bond positions, creating a world in which some Muni's which are backed by Treasuries, present a BEFORE tax yield greater than Treasuries (the chart above shows the entire Lehman Brothers index).

Source: Lehman

Back in February Fortune ran a nice article as to why non-taxable municipal bonds "muni's" were a buy NOW:

Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis' tax advantages. Throw in munis' microscopic default rates, and you've got an ideal landing spot for investors weary of the stock market roller coaster.

In theory I agreed with all the points. The article even pinpointed the danger of investing in muni close-end funds, which trade like stocks:

With a fund, given the vagaries of interest rates, bond prices and net asset values, there's no way of knowing what price you will get when you decide to sell your shares.

However, the author did not understand how large a risk this really was in an environment where returns of stocks and close-end funds become highly correlated, which is what happens when EVERYONE is deleveraging (i.e. selling) at the same time. Throw in the bad press many of these close-end funds had after the auction-rate security debacle and you get an investment (in a high-quality muni close-end fund) down as much as 35+% since February (of which about 10-15% is due to the underlying muni bond exposure).

What the author failed to foresee was that the while municipalities have low historical defaults (and high quality municipalities will likely remain that way through the turmoil), technical factors in credit AND equity markets were about to deteriorate, causing twice the pain for close-end muni funds:

Forced Muni Selling by Banks / Hedge Funds:
Broker-dealers and hedge funds were forced (and continue) to unwind major muni positions, shedding as much as 20% of all the outstanding issues held at brokerages, in an attempt to delever and raise capital.

Frozen Credit Markets:
There are currently no natural buyers of any risk in credit markets and muni bonds are no exception. Fear has driven many traditional investors to the safety of Treasuries. Thus, anyone selling muni's gets a significantly lower price, which in a mark to market and illiquid world becomes the new price. Long dated muni's currently trade at a yield 1.45x that of Treasuries (with the tax savings associated with muni's, this should be at or below 1x given conservative assumptions).

No Demand for Close-End Funds:
Muni close-end funds traded at a roughly 5% discount to the net asset value of the underlying holdings as recently as May of this year. The recent market turmoil has caused this discount to spike to 20+% in many instances as owners are unloading close-end funds, along with their equities (i.e. throwing the baby out with the bath water).

So where does this get us? The 20% discount presents a significant cushion and opportunity going forward. It is important to note that muni's have survived many brutal economic environments in the past, but did see high levels of defaults during the great depression (unlike many bears on the blogosphere, I do not see us approaching anything near that level - hopeful news here).

To be extra safe, I would sacrifice yield for additional credit quality, although in an environment in which a AA rated municipality is in trouble, it is highly likely a AAA one will be as well. However, in a low yielding environment (such as this one), I am happy to take on the risk associated with a AA rated muni-close end fund, at the current 20% discount, which yields MORE THAN 8% AFTER TAX in many cases. That is the equivalent to a before tax yield of 9.4% (if your tax rate is 20%) and a whopping 10.5% (if it is 35%). Considering the risk embedded in the S&P 500, and an average return on the S&P 500 (including reinvestment of dividends) of only 8% over the last 20 years BEFORE taxes, I like the risk-return profile.

My obvious hope is the market rebounds significantly, but even if the underlying asset values and close-end continue to sell off due to continued selling pressure, I'll collect my boring 7.5% tax free coupon until the cows come home.

Note: Before any investment, please do your own research. 'Muni X Close End Fund' is "based" on a real fund (i.e. it's real).