You have to credit Meredith Whitney with one thing: She really galvanized people to take a look at the muni market. Some have decided she and other super bears are nuts. Others are nervous and looking to hedge.

That brings up an interesting issue raised by the Financial Times. How do you go about shorting such bonds?

Classic short selling may not work as borrowing the bonds to short looms as a huge challenge. That leaves some sort of derivative play. Credit default swaps immediately come to mind.

"But the market in muni CDS is a fraction of the size of other markets in credit derivatives used to speculate on the default risk of companies or countries," notes the FT. "Needless to say, state and city authorities are far from keen on a growing muni CDS trade. Local government officials in California and Illinois worry that such speculation will exacerbate their problems. They have discouraged muni derivatives trading."

Some are also looking at CDSs tied to indexes, which are equally illiquid. Citigroup is looking into creating a structured bond tied to an index that would be tranched to offer different levels of risk.

It remains to be seen how far this will go. But the early predictors of the mortgage meltdown similarly looked for innovative ways to short the market. Whether this muni-related effort proves to be that profound is unknown, though it does not seem nearly as likely. But that's what people said about the mortgage-backed market before it imploded.

For more:
- here's the FT article

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