"Other than the New York City financial crisis of 1975, this is the most dramatic event that has happened in the municipal market in the 20 years that I have been in the business," a veteran Wall Street municipal bond manager said, referring to Salomon Brother's decision to close its municipal operation last week.

"Salomon Brothers was one of the major municipal dealers who supplied a great deal of liquidity for the market, as well as the raw material," added Peter Gordon, who manages T. Rowe Prices' multifaceted municipal operation. "There is not any one firm with that type of capital that will replace them soon. They will be missed."

Why would a major force in the municipal market abandon a lofty position that it had fought so hard to create over the past 20 to 30 years? There are several complex factors that led to Salomon's dramatic announcement.

The Tax Reform Act of 1986, with its far-reaching implications, was one major factor in causing Salomon's problems. First, it sharply curtailed the types of new underwritings that could be marketed, especially certain kinds of "private purpose" revenue issues. This led to a steep decline in municipal underwritings.

Second, this curtailment has led to a change in the mix of new underwritings. Previously, the mix was 65 percent to 70 percent in favor of revenue issues. Now the mix is in the process of swinging back to the 50-50 ratio of revenue to general obligation bonds that existed some 8 to 10 years ago.

This is important because commercial bank municipal departments {dealer-banks} by law can bid only on general obligation underwritings (although in recent years, they have been able to somewhat get around this restriction). The banks are able to raise funds more cheaply to carry their positions, so they have become a more formidable competitor for the broker-dealers.

Further, since tax reform was passed, there has been no major reduction in municipal underwriting and trading operations on Wall Street. Concurrently, as underwriters have continued to carry their large staffs and therefore a large overhead, issuers of municipal bonds (states, cities, etc.) have pushed for a reduction in underwriting fees at a time when competition has increased between the dealer-banks and the broker-dealer community.

On the buy side of the coin, institutional buyers have been able to beat underwriters out of part of the built-in fees found in the "concession." For example, if the underwriter's concession was 1 point, many of the buyers would demand and receive as much as a one-half or three-quarters of a point of the concession. The bottom line was high overhead, volatile markets, reduced supply, paper-thin profit margins and large capital commitments needed to play the game.

This in turn led to overbidding in an effort to win new issues. This meant that the new issues were initially priced too high and were unsalable. Large trading losses resulted as prices on the unsold issues had to be cut to sell them to clients. It is rumored that Salomon's trading losses so far this year are around $100 million.

Lastly, Salomon Brothers is involved in a global securities market. "It takes a tremendous amount of capital to compete in a global market environment," Gordon noted. "Salomon is the first to realize that they didn't have enough resources to be in all markets."

Faced with these difficult problems and limited resources, Salomon simply decided to put its capital where it could earn the most money. You cannot help but wonder how many more Wall Street firms will follow suit. James E. Lebherz has 28 years' experience in fixed-income investments.