March 3 (Bloomberg) -- U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities.

California, Boston's biggest hospital and Duke Energy Corp. are converting bonds to other types of tax-exempt debt after auction failures drove rates as high as 20 percent. The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989.

Rates increased last month as investors shunned the securities on concern the insurers that guaranteed the debt may be downgraded, and as dealers refused to buy bonds that went unsold at auctions. The higher borrowing costs are squeezing states and towns just as slower growth threatens to cut revenue.

``It's a supply tsunami,'' said Robert Fuller, principal of Capital Markets Management LLC in Hopewell, New Jersey, a financial adviser to municipalities. ``All of that is going to be redone, and it's going to be redone fast,'' he said of auction-rate bonds.

Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Washington-based Center on Budget and Policy Priorities.

Jefferson County

Standard & Poor's slashed the ratings on $3.2 billion of debt issued by Jefferson County, Alabama, to below investment grade on Feb. 29, citing costs from auction-rate and other bonds and interest-rate swaps used to finance its sewer system.

``The county can provide no assurance that net revenues from the sewer system will be sufficient to permit the county to meet the interest rate and amortization requirements of the liquidity facilities,'' officials said in a notice last week.

For at least a decade, auction-rate bonds allowed municipalities, closed-end funds and student lenders to borrow long term while getting short-term rates with securities whose yields are reset by bids every seven, 28 or 35 days. In auction bonds, when there aren't enough buyers, the bidding fails and rates are set at a level determined in official statements issued at the initial bond sale. Investors are suddenly left holding securities they may have wanted to sell.

Municipalities sold about $166 billion of the bonds, or half the $330 billion total, according to estimates by Bank of America Corp.

Failure Rate

The market started falling apart last month as banks from Goldman Sachs Group Inc. to Citigroup Inc. permitted thousands of auctions to fail by not buying bonds that went unsold. At least 60 percent of auctions haven't attracted enough bidders since Feb. 13, based on Bank of America and Bloomberg data.

The four largest agents that take orders from dealers and determine winning rates reported failures on 379 out of 547 auctions today, or 69 percent, figures compiled by Bloomberg from Deutsche Bank AG, Bank of New York Mellon Corp., Wells Fargo & Co. and Wilmington Trust Corp. data show.

There were fewer than 50 failures in total from 1984 through 2007, Moody's Investors Service said.

``We're in a brave new world right now,'' said Ross Berger, head of proprietary municipal credit and a portfolio manager at Wells Fargo Bank in San Francisco.

Yields on top-rated, fixed-rate bonds due in 30 years rose to 5.01 percent today, the highest since July 2004, based on data from Municipal Market Advisors. A Bloomberg index of variable-rate demand note yields jumped almost 2 percentage points to 3.17 percent last week.

Market Anomaly

Municipal yields are rising as those on Treasuries fall, creating a market anomaly, since local government debt is exempt from taxes and bonds sold by the federal government isn't. Top- rated, 30-year municipals last week offered yields that were 10 percent higher than Treasuries of comparable maturity, the most in more than 11 years, Citigroup strategist George Friedlander said in a Feb. 29 report.

Hedge fund managers sought to sell as much as $3 billion of municipal securities last week, traders said. ``Bids wanted'' totaled $1.1 billion on Feb. 28, after averaging $601 million the past 90 days, according to a Bloomberg index.

The auction-market fallout also is affecting student lenders and for-profit corporations. The Pennsylvania Higher Education Assistance Agency, the second-largest municipal seller of auction-rate debt for the past seven years, said it will stop making student loans after paying $24 million in extra interest. Louisiana-Pacific Corp., the Nashville, Tennessee-based lumber company, said last week it will take a charge of about $46 million to $54 million to write down its investments in auction- rate securities.

California Converts

California, the biggest municipal borrower, is exploring ways to replace $1.25 billion of auction-rate bonds after yields on some of the debt almost doubled to 6 percent. Other states including Wisconsin are working on plans to convert their high- cost debt, as are agencies such as the New Jersey Economic Development Authority, which today approved plans to convert or refinance $1.3 billion of the securities.

The board of Charlotte, North Carolina-based Duke Energy last week approved plans to replace $883 million in auction-rate bonds that its utility subsidiaries sold in the municipal market. Boston's Partners Healthcare System Inc. this week plans to begin converting $150 million into variable-rate demand notes, which unlike auction securities permit investors to ``put'' the bonds back to the issuer or liquidity provider.

Partners, the parent of Massachusetts General Hospital, is also exploring replacing another $300 million in auction bonds. Some issuers are preparing to convert their auction bonds into a different type of variable rate and others are considering refinancing the debt into long-term fixed rate securities.

``When you've got many issuers representing hundreds of billions of dollars trying to restructure their bonds all at once, there's obviously a glut,'' said Paul Rosenstiel, California's deputy treasurer. ``It doesn't make for any easy solutions.''

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net

Last Updated: March 3, 2008 17:37 EST