The muni-market hearings in Washington today might be a bit of a snore, but Michael Corkery’s long curtain-raiser for them in the WSJ is a good one, and serves to begin the slow yet necessary process of moving beyond loud and simplistic questions along the lines of “Meredith Whitney: threat or menace?”. Whitney is certainly a natural locus for debate, but the problems of the muni market are much bigger than one loudmouthed analyst trying to make a splash while at the same time keeping her report secret.

For one thing, as I said back in December, the question really isn’t whether Whitney is right or wrong. Chances are, there won’t be hundreds of billions of dollars in defaults. But so long as such a thing is possible, and the markets are having difficulty quantifying and pricing in the relevant probabilities, the muni market as a whole is going to remain in difficulties.

More immediately, munis have a very real liquidity problem, and no easy way to deal with it. Here’s Corkery:

If the $2.9 billion market continues to struggle, it will be because of the attitude of investors like Barry Fiske, an account manager for a Boston-area heating and air-conditioning contractor.

Mr. Fiske, 61 years old, had long considered muni-bonds a safe investment. But late last year, he says, he “just felt very uneasy” about the “threats [facing] certain states like Illinois, California, New Jersey and maybe New York.” He slashed his holdings in muni-bond funds to 5% of his investment portfolio, from 20%…

Individuals like Mr. Fiske own about two-thirds of U.S. municipal bonds, directly or through mutual funds. This was long seen as a positive, because individual investors tend to “set it and forget it,” says Ms. Fell. But individual investors have been sellers of shares in muni-bond mutual funds for 12 consecutive weeks. Since early November, individuals have pulled a net $23.6 billion out of these funds…

When individuals step away from the muni-bond market, there are a limited number of other investors to take their place. The tax-exempt returns that lure individuals aren’t as attractive to larger investors, such as hedge funds and investments banks.

Some states and cities have cut back on borrowing in the face of diminished demand for their bonds, which creates higher costs for borrowers. A New Jersey agency trimmed a refinancing by 40% last month.

But states don’t always have that option.

If the individual bid continues to go away, there’s a real problem here for the muni market — at some point, the amount of bonds that states need to issue might well exceed the amount of demand in the market. At that point, bad things happen. The amounts here are far too big for states to go to the loan market instead: if investors won’t buy bonds, banks won’t lend the states the money they need.

So what happens? Bonds designed to finance infrastructure investment would probably not get issued at all: that means layoffs in big construction projects, and a big overhang of unissued debt which would make it that much harder for the muni-bond window to open again. More generally, states would have to start becoming much more attractive to institutional, as opposed to retail, investors. But because institutional investors don’t get the same tax benefits that individuals do, yields would have to rise — and prices would surely fall.

In other words, there are lots of very good reasons why we might see substantial price decreases on muni bonds, even without any fears of default. All you need is the retail bid to go away, which happens for all manner of reasons: fewer bonds are being insured, for one thing, and also individual investors are generally smart enough to know that they’re not remotely sophisticated enough to judge creditworthiness on their own. Muni bonds have always been a safe investment with tax advantages; now, they’re something else. They’re much more volatile (ie, less safe), and the market is showing (in this nifty Financial Times graphic), that there’s substantial credit risk where none was really considered to exist in the past. In other words, there’s risk in these things, and muni investors tend to be extremely risk-averse.

It makes sense, then, as the FT reports, that there’s a lot of interest in shorting the muni market, even among people who don’t take Meredith Whitney seriously at all:

“There is a lot of blood in the water in the municipal space. Hedge funds smell that blood and are trying to figure out the best way to make money in the marketplace,” says Rob Novembre, head of municipals at Arbor Research and Trading…

Citigroup, for example, is studying a structured bond which would be directly linked to the performance of the municipal bond index, called MCDX.

This is clearly bad news for municipal issuers: investors wanting to buy the muni market on dips will now have a more liquid alternative to buying actual bonds, and can buy Citi’s synthetic instrument instead. Already the rise of muni ETFs has exacerbated volatility in the market. Expect the muni market to become more financially sophisticated in coming months, with a corresponding uptick in volatility. This is going to be a very bumpy ride for anybody issuing general-obligation bonds, even if there isn’t any signifiant default risk. Just because you’ll pay the money back, doesn’t mean you can borrow the money.

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Felix Salmon is an Audit contributor. He's also the finance blogger for Reuters; this post can also be found at Reuters.com.