SAN FRANCISCO - A few stubborn California municipal bond issuers just won't let go of that bond insurance they paid for.
The San Pablo Redevelopment Agency and the Oxnard Finance Authority recently restructured Ambac Assurance Corp.-insured variable-rate demand obligations by wrapping the notes with a direct-pay letter of credit from Union Bank of California and keeping the insurance in place.
The Bay Area Toll Authority negotiated with Ambac to win a commitment to reinstate their insurance policies at no cost in three years if they want it.
"Ambac may still be around in the future," said Mike More, the financial services director in Oxnard, a city of 200,000 about 60 miles northwest of Los Angeles. "We already paid for the insurance, so we have nothing to lose and something to gain if they regain their triple-A rating."
Issuers of insured variable-rate debt faced a spike in interest rates earlier this year, when Ambac and most other bond insurers were hit by credit rating downgrades due to exposure to mortgage-backed securities. Investors shunned the debt out of fear that insurer credit woes would lead banks to pull liquidity support for the deals.
Most issuers rushed new debt to market and wrote off the value of the millions of dollars in insurance premiums they had paid when insurers had triple-A ratings. In the early days of the credit crunch - when Ambac and MBIA Insurance Corp. still had their triple-As - a fair number of issuers tried to salvage their insurance. Most have given up since the insurers lost their top credit ratings.
But a hardy few continue to work to salvage their insurance, betting the credit crunch will pass and restore value to their policies. Most said they would only bother trying to salvage coverage from Ambac and MBIA, which have maintained relatively high investment-grade ratings.
The Oxnard Finance Authority bought Ambac insurance for three deals issued in 2003, 2004, and 2006 with a Dexia Credit Local standby bond purchase agreement as liquidity.
When Ambac lost its triple-A ratings from the three major credit agencies earlier this year, rates on Oxnard's $60 million of debt shot up to as much as 7%, according to More.
The finance director knew the city had to do something about the rise in rates, but didn't like the idea of wasting the "hundreds of thousands" of dollars he spent on bond insurance just a few years earlier.
So Oxnard restructured the debt to replace Dexia's standby bond purchase agreement with a letter of credit from Union Bank, while keeping the insurance policy in place as a third line of protection for investors.
The Finance Authority promises to pay the debt. If it doesn't make good, Union Bank is on the line to pay any claims to bondholders in case of a default or failed remarketing. It will have to pursue Oxnard and Ambac for repayment in case of default.
The structure seems to have worked. Standard & Poor's gave the deal a AAA rating based on the joint creditworthiness of Union Bank and Oxnard. De La Rosa & Co. remarketed the notes with the new structure for the first time this week. The notes, which are in weekly mode, priced to yield just 1.6%, down from the 4% range in the weeks before the restructuring and 7% at their peak.
San Pablo has seen similar results with a Union Bank letter-of-credit wrap on its Ambac-insured VRDOs.
"Since the LOC was put in place the remarketing rate on our bonds has averaged only 1.48%, which is even lower than the 3.50% rate we averaged from October 2006 until Jan. 21, 2008," when the original VRDOs were functioning properly, according to San Pablo finance director Bradley Ward. The deal was underwritten by Piper Jaffray & Co.
"Although we remain hopeful that Ambac will eventually recover its triple-A ratings and acceptance among money market fund managers so we can terminate the LOC and go back to the original structure with insurance and liquidity, we are fully prepared to retain the LOC for the entire term of the bonds, if necessary," he said.
Investors say they're fine with a structure that keeps insurers as a backstop. They just don't want direct exposure.
"We don't have any misgivings about buying insured paper wrapped by an LOC," said Laurie White, a managing director with Wells Capital Management, which has bought into similar transactions. "At that point our credit exposure is to the LOC provider."
The restructuring was a good idea for Oxnard because it keeps open the possibility of replacing the LOC with a less costly standby bond purchase agreement if Ambac is able to regain its triple-A ratings and market acceptance.
"The beauty of the structure is that it's a future opportunity," said John Kim, the De La Rosa investment banker on the deal.
That doesn't mean it was simple to pull off. It required several months of negotiations between lawyers for Union Bank and Ambac to determine which rights each would have in a default and the exact flow of payments - or "waterfall" - on the deal.
"It was probably the most complicated transaction we ever had," said Oxnard's More.
Getting the flow of funds right is critical for investors who are worried about exposure to insurers and loss of liquidity.
"Since there is no industry-standard documentation, you really have to read the documents carefully to ensure that the LOC is paid before the insurance, that it is paid directly to the holder of the security, and that it cannot be terminated because of any credit-related events impacting the monoline insurer," White said.
Such agreements have been tough to make since Ambac was downgraded, said Don Farrell, a managing director at the insurer. Earlier in the year, the company did several similar deals before it was downgraded. Now, with business overwhelming most LOC banks and the uncertainty around Ambac's credit rating, most banks aren't interested in negotiating such complex deals, Farrell said.
The key for Oxnard was that Union Bank was willing to negotiate an agreement with Ambac. The two credit enhancers developed a model for such agreements on a smaller deal for San Pablo, which is near San Francisco.
"We usually have to customize solutions for our clients," explained Kenneth Huff, senior vice president and manager of public finance at Union Bank. He declined to discuss the precise details of the San Pablo and Oxnard transactions, but he confirmed that the bank has only done two deals like this.
Huff also said he'd be willing to work with other issuers seeking a similar solution. He added that Union Bank still has capacity to issue LOCs this year. Sales of LOC-backed VRDOs surged to a record in the first half, as issuers sought to refinance auction-rate securities and insured VRDOs. Many market players have complained recently that banks have run out of capacity to issue new LOCs.
"Send them my way," Huff said.
While many - perhaps most - issuers are taking a complete loss on their insurance as they rush to refinance, Farrell said Ambac is willing to do more restructurings with letter-of-credit wraps.
He's just not sure if the LOC wrap is the easiest route because of the time involved in negotiating an agreement between the LOC bank and the insurer, time during which issuers are paying higher than usual interest rates.
Farrell said it may be quicker for Ambac to issue the sort of forward insurance commitments it offered to the Bay Area Toll Authority in its $1.6 billion restructuring of Ambac-insured variable-rate debt. The approach was pioneered earlier this year in a $499 million deal for the Orlando-Orange County Expressway Authority in Florida.
BATA demanded such a forward-insurance commitment when it refinanced. Under the agreement the insurer committed to reinstating the insurance at no cost in three years.
The authority refinanced without a letter of credit because its double-A level credit ratings were high enough to market variable-rate debt without any enhancement.
"The policy delivered value and if the market gets saturated with uninsured debt, we keep an option in our pocket and there is hope the market restores some of its value," said BATA chief financial officer Brian Mayhew.
He doesn't think investors are necessarily going to embrace insurance again anytime soon, but as LOC banks see the risks they are taking in providing liquidity and credit enhancement, they may begin to appreciate whatever bond insurance that issuers can maintain.
"I believe insurers provide the formula to lower liquidity risks and costs" because it provides a way for banks "to mitigate the creditor of last resort" exposure they are taking on, Mayhew said.
While Farrell acknowledged that Ambac was especially keen to keep BATA happy because the operator of San Francisco Bay Area toll bridges is a major customer, he said the insurer is willing to make similar arrangements with other government issuers. He said he can put forward commitments together without the time-consuming negotiations included in LOC wraps.
"We're the ones that screwed this up," Farrell said. "We are trying to make things work for the issuers."
