CNBC has been reporting this afternoon that several hedge funds that use leverage to invest in the municipal bond market are being forced to sell. The size of the offers are huge and prices have been marked down significantly to attract buyers. The stress in the muni market first showed up several weeks ago in the auction rate market and is now spreading to regular munis. I don't expect this is the end either; closed end funds that issued auction rate preferreds will be forced at some point to call those securities if the auction rate market continues to fail. If they are forced to pay off the preferreds they will be selling munis to cover the cost. Expect to see more selling next week.
I also suspect that at least some of the selling in stocks today is related to the muni meltdown. If a leveraged hedge fund is getting margin calls because of municipal bonds and they can't sell the bonds, they will sell what is liquid to cover the margin call. And today that appears to be stocks.
Take a look at this chart of the Municipal Bond ETF:
That's about a 7% drop in just over a month. Muni bonds are one of the safest places to invest and a drop like this in such a short period of time is unprecedented as far as I know. The muni market usually tracks the Treasury market fairly closely, but in the last week the two markets have gone in completely opposite directions. The aversion to risk being shown in the market is amazing.