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Cleveland Winds Up ARS

CHICAGO - Cleveland is expected to issue nearly $290 million of variable-rate airport revenue bonds today in a transaction that marks the city's last major refinancing in its months-long effort to convert all of its outstanding auction-rate securities.

The transaction comes as airport officials have slashed an already-lean capital plan after its largest carrier, Continental Airlines, announced plans to reduce service like other major U.S. airlines as the industry grapples with rising jet fuel prices and a sagging national economy.

Benefiting from stable finances and low future debt plans, Cleveland-Hopkins International Airport is also working to increase its non-airline-related revenue as it navigates the skittish sector over the next 30 months, airport analysts said.

Today's $288.1 million issue is divided into eight series - one as small as $3.3 million - and is supported by letters of credit from four separate providers, reflecting the complexity of pulling together credit enhancement as banks are increasingly reluctant to provide credit on big chunks of debt. The variable-rate demand bond issue includes about $68 million of taxable debt. While interest earned on most of the debt is subject to the alternative minimum tax, a small piece is not.

"It took us awhile to piece together enough LOC capacity" to go ahead with the issue, said Elizabeth Hruby, Cleveland's debt manager, who kept a chart pinned to an office wall to help her keep details of the complicated deal straight. "This is an evolving situation. We went to some of these banks probably six months ago, and things have changed over time. Some would drop out and some would come in. Eventually we were able to piece together the amount we needed."

The airport refinancing is the city's third - and largest and most complicated - since it began in April to convert all its ARS to another mode. Most of the debt experienced failed auctions at one point or another, translating into unexpected interest rate costs, some of which are paid out of the city's general fund, Hruby said. The City Council approved legislation allowing the refinancing in February.

Proceeds from today's issue will be used to eliminate all of Cleveland's airport debt originally sold in 2003 and 2007. The debt was insured by Ambac Assurance Corp. and XL Capital Assurance Inc.

Auctions on the 2003 debt, totaling around $140 million, failed consistently over the last several months, with interest rates reaching about 5%, said Hruby. Auctions of the 2007 debt, which totaled around $148 million, did not fail, though interest rates reached 5.40% - well below the maximum default rate of 15% on that debt, but above index rates.

Of the upcoming $288.1 million issue, Series A, B, and C total $150.1 million and will be supported by a letter of credit from Wachovia Bank NA. Series D and H, which total $22 million, will be supported with an LOC from U.S. Bank NA. Series E and G, totaling $58 million, will be supported by an LOC from KBC Bank NV, and Series F for $58 million will be supported by an LOC from UBS AG.

The city hired three underwriters to handle the separate series - JPMorgan, Wachovia Securities LLC, andRBC Capital Markets. Government Capital Management LLC and Phoenix Capital Partners are the city's financial advisers. Bond counsel is Squire, Sanders & Dempsey LLP.

Officials selected the underwriters in part based on proposals and in part because they agreed to provide credit enhancement, according to Hruby.

"Wachovia stepped up for quite a bit of LOC capacity, so we did want to include them [as underwriters]," she said. "That was the fair thing to do."

Wachovia also provided letters of credit on Cleveland's $108 million of stadium certificates of participation, which was the city's first auction-rate refunding in April.

Ahead of the transaction, Fitch Ratings affirmed its A rating on Cleveland Hopkins International Airport's outstanding debt, which will total around $909 million after today's sale. Moody's Investors Service affirmed its A3 underlying rating and Standard & Poor's affirmed its A-minus underlying rating on the airport.

The airport's bonds are secured by gross airport revenues and certain special funds, including federal grant money. The airport system includes Cleveland-Hopkins International Airport as well as Burke Lakefront Airport. The various revenues have provided at least 1.36 times coverage of annual debt service over the last five years.

Hopkins is the chief commercial airport in northeast Ohio and enjoys a strong base of demand, limited competition, and strong liquidity, according to analysts. The airport is further strengthened by its strong origination-and-destination traffic, which accounts for about 77% of its total passenger traffic. The airport is also boosted by the presence of Southwest Airlines, its second largest carrier and one of the highest-rated domestic airlines.

But like other airports across the county, Hopkins is facing deteriorating airline revenue as many U.S. airlines, struggling with rising jet fuel costs, cut service and consider consolidation.

Airports like Hopkins that rely heavily on one or two domestic carriers for revenues are particularly vulnerable. Continental Airlines accounts for 66% of all Hopkins' enplanements, and announced in mid-June that it would cut up to 13% of its seats at the airport beginning this fall. Hopkins is not expected to take as big a hit as Houston, another Continental hub, but airport officials reacted to the announcement by slashing nearly in half an already modest $213 million capital improvement plan.

Continental's announcement comes a year after the airline increased its service at the airport. The short-term impact of the service cuts, therefore, is likely to return traffic to 2005 levels, when passenger levels reached about 5.7 million, said city officials and analysts.

"It's expected that this is Continental's first step, and in the short term it means the airport is reviewing its capital plan for any additional costs that can be cut," said Moody's analyst Kurt Krummenacker. "It's a similar story at many of our rated airports that are seeing declines of this magnitude, but in this case it will just nullify the growth that Continental has put in place over the last year to 18 months."

Airline service reductions translate into higher costs-per-passenger enplanements, or CPE, which at Hopkins are already elevated, analysts noted. Hopkins' current CPE is $9.95, while the industry median is $5.87, according to Moody's. The airport's CPE could rise to a peak of $12.84 in 2011 if traffic declines 5% next year, then remains flat in 2010, according to Fitch.

"As these airlines go through these capacity reductions, the cost per enplanement is going to go up," said Fitch analyst Peter Stettler. "We're going to watch and see how CPE adjustments affect each airport, and the comparability amongst their peers. How the economy plays out is going to be a very key factor over the next couple years."

In another effort to prepare for declining revenues, Hopkins' officials recently revamped their concessions program, a move that should at least keep revenues at current levels.

"They've already been doing a nice job of trying to wean themselves off of airline revenues, however some of the non-airline revenues are dependent on passengers," Krummenacker said.

The airport so far has not announced plans to explore other revenue sources that are not tied to passenger traffic, such as land-use agreements.

After today's transaction, the airport will have about $909 million of outstanding debt, of which $575 million is variable rate, according to Hruby. Roughly $200 million of the variable-rate debt is hedged through floating-to-fixed-rate swaps that will remain in place after this week's deal.

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