SAN FRANCISCO - The liquidity that lubricates the variable-rate bond market is drying up.
Municipal issuers such as the Bay Area Toll Authority, the Los Angeles Department of Water and Power, San Diego County, the Santa Clara Valley Transportation Authority, and Los Angeles say banks are no longer competing to sell them letters of credit and standby bond purchase agreements.
Those issuers are major, highly rated local government entities. All are in California, but they exemplify a national trend that's complicating efforts to restructure auction-rate bonds and variable-rate demand obligations that carry insurance from insurers that have been downgraded - fewer banks are bidding on deals. They are offering shorter commitments with tougher terms, and they are charging more for it.
"It's very tough to get new liquidity right now, both from the standpoint of price and from the standpoint of the number of banks that are still active," said financial adviser Vincent McCarley, chief executive officer of Backstrom, McCarley Berry & Co. in San Francisco. "There are fewer participants, and they've already done a huge volume this year."
McCarley helped San Francisco International Airport sell about $1 billion of variable-rate debt in the first half, as the airport restructured its auction-rate securities. The bonds were part of a record $73.3 billion of variable-rate demand obligations issued nationwide in the first six months of the year, a 300% jump from the same period a year ago, according to Thomson Reuters.
Municipal issuers need an LOC or SBPA when they issue VRDOs because investors can demand repayment on short notice. Prices for both forms of liquidity jumped after the auction-rate securities market seized up earlier this year, prompting a surge in demand for LOCs and SBPAs as issuers refinanced into variable-rate demand obligations.
As insured VRDO remarketings started to fail more frequently, banks realized that standby bond purchase agreements are often just purchase agreements and started pricing accordingly.
Issuers report paying 40 to 50 basis points on the amount issued for each year of protection with an LOC, which is several times more than they paid just a year ago. In extreme but rare cases, they've reported paying up to 80 basis points.
Prices are lower for standby bond purchase agreements, and they're a bit easier to get because they put banks at less risk. An LOC provides both credit enhancement and liquidity, while an SBPA offers just short-term liquidity for an issuer.
That doesn't mean they're cheap or easy to find.
LADWP last month paid about 40 to 50 basis points to get new SBPAs from JPMorgan Chase Bank NA, Lloyd's TSB Bank, and Landesbank Hessen-Thueringen for $388.5 million of power system revenue bonds that were originally issued in 2002. The banks would only commit to one-year liquidity agreements, not the three-year commitments LADWP sought.
The prices were five to six times more than the municipal utility paid when it got three year commitments last year, said Mario Ignacio, LADWP's director of finance and risk control. He had to take the only bid he could get and was glad to get liquidity at all.
"If you don't have an existing relationship with a bank, you're probably not going to get liquidity," he said. "This market is a mess right now."
He said he won't issue new variable-rate debt until the price and availability of liquidity improves. LADWP plans to sell fixed-rate debt when it returns to market with new bonds later this year.
Issuers have traditionally combined SBPAs with insurance. Money market funds are the biggest buyers of VRDOs, and their investment guidelines and Securities and Exchange Commission Rule 2a-7 limit their holdings to paper rated at the double-A level and higher. But issuers with double-A level credit ratings like LADWP are increasingly relying on their own credit and going to market with just an SBPA.
That's what the Bay Area Toll Authority decided to do when it restructured $2.4 billion of Ambac Assurance Corp.-insured variable-rate debt with VRDOs. BATA is one of California's most sophisticated variable-rate issuers. It has double-A level ratings from all three credit rating agencies and has existing relationships with many liquidity providers.
But BATA didn't just face higher prices when it sought liquidity. It had trouble lining up the standby bond purchase agreements for the full amount it needed, said chief financial officer Brian Mayhew. He had to convert more than $500 million of the debt into fixed-rate bonds and had to accept shorter terms than he wanted on some of the liquidity. He wanted three-year commitments but accepted a one year SBPA for part of the deal.
The authority negotiated for seven months with its banks to reduce non-notice suspension and termination provisions that it worried would frighten off investors. Mayhew said he understands why banks are reluctant to commit to deals because they've been stuck holding a lot of bonds they didn't want this year.
"They will probably hold all the bonds at the end of every agreement and that really scares them," he said. "As such, they continue to insert provisions that will prevent them holding bank bonds at all, but those provisions scare the investor away."
The lack of liquidity made his recent restructuring more complicated and more expensive. In addition to higher interest rates on the fixed-rate bonds, BATA had to enter swap agreements to offset the swaps that synthetically fixed the rates on the variable rates it was forced to convert to fix-rate debt.
BATA and LADWP aren't alone. Issuers across the country tell similar stories about their recent attempts to find liquidity. That's convinced some hospitals and universities to just provide their own liquidity via their large cash reserves. But that's not an option for most local governments.
For them, McCarley, the financial adviser in San Francisco, suggests a sharply targeted search for LOCs.
"They're not going to get much of a response from doing a broad-scale [request for proposals]," he said. "They need to look at their relationships where they've got a deposit, trustee or other relationship that they can hopefully leverage to generate some interest."
The other option is to wait out the storm.
"The variable-rate market has served issuers very well," McCarley said. "But in today's market, if you are making a decision between a variable-rate issue and a fixed-rate issue, I would recommend a fixed-rate issue."