In recent months, states and cities have lobbied for their piece of the bailout pie. Among other requests, they’ve asked the federal government to support municipal bond markets by directly buying municipal bonds through the new programs that the Treasury and Fed have set up to buy everything from mortgages to credit-card debt. Mortgage Market Advisers warns us today why this proposal may be a bad idea.

“[A]ny buying program should NOT entail direct buying of long-maturity muni paper,” MMA warns. “This would effectively create a new, but temporary institutional demand component for bonds that would rally the market while it persisted but ultimately undermine future issuers when Treasury needs to unwind its muni portfolio.”

In other words, MMA figures that if Treasury (or the Fed) amasses a big portfolio of muni bonds, investors soon would figure that the government, eventually, would have to sell those bonds, depressing prices as it flooded the market.

So private investors would wait to buy bonds until the federal government had done most of its selling work, further distorting the real market for supply and demand.

Of course, one could say the same thing about all of the government’s new credit-creation programs …

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