WASHINGTON - Municipal issuers holding swap contracts and hundreds of millions worth of guaranteed-investment contracts with American International Group Inc. are safe and not likely to loose their investments, sources said yesterday, while other municipalities worried what would happen to AIG's large muni holdings.
AIG's credit downgrade from triple-A to the single-A range has triggered provisions in the interest-rate swaps and other derivative contracts held by many municipalities that require the insurance firm to post additional collateral. Issuers said they are beginning to discuss AIG's contractual options and whether a derivative needs to be unwound.
"The only thing the issuer may lose here is a little sleep. They shouldn't lose any money," said Nat Singer, managing director with Swap Financial Group Inc. LLC in South Orange N.J., which has been advising municipalities as they unwind their swap agreements with AIG and Lehman Brothers Holdings Inc.
Issuers that now have the option to terminate their contracts with AIG may find they will have to pay a settlement fee to AIG even though the beleaguered insurance firm was the counterparty stung by a ratings downgrade. Since interest rates are lower now than when many of the municipalities entered their swap agreements with AIG, the issuers may owe a premium if they want to terminate their swap.
"If AIG were to be the bad guy, the trade would be broken at the municipal entity's side of bid-offer spread," Singer said.
The unwinding process will eventually be a neutral wash for municipalities if they can find a new counterparty to take over AIG's position. Another counterparty should be willing to pay a premium to step into AIG's shoes because they're receiving a higher-than-market rate.
"By definition, the amount that counterparty is willing to pay the muni issuer is the amount the muni issuer needs to pay to AIG to settle the trade," Singer said. "The level [is] exactly where the issuer would replace the trade with another counterparty."
But tax stipulations may add additional burdens for the issuers looking to exit agreements.
"The tax questions for unwinding an AIG swap depend primarily on whether the swap has been integrated with the bonds," said Todd Greenwalt with Vinson & Elkins in Houston.
Municipalities also entered into GIC agreements with AIG - contracts that guarantee the owner principal repayment and interest rate payments for the life of the contract. As with the swap agreements, AIG's credit downgrade, not the federal bailout, triggered provisions in the GIC contracts, sources said. As a result of the downgrades, sources said AIG is obligated to take one of three options: post additional collateral, assign the contract to a new holder with the approval of counterparty's bond insurer, or cancel the contract.
The Louisiana Public Facilities Authority in Baton Rouge initiated a $13.8 million GIC with AIG in 1998. The issuer said yesterday it was sending a letter to AIG asking the company what action they will take under the contract. If AIG's ratings are downgraded again below A3, LPFA has the option to cancel the contract, said James W. Parks, the president and CEO of LPFA.
AIG's credit downgrades, tied to its losses from the mortgage market, ultimately forced the Federal Reserve to provide the firm with financing. The Fed announced late Tuesday that it will lend AIG $85 billion under a provision in the Federal Reserve Act, which allows the Fed to lend reserves to any business suffering "unusual or exigent circumstances." The Fed will lend AIG fund at LIBOR plus 8.5 percent. In addition, the government will take a 79.9 percent equity stake in AIG and can veto any dividend payments to AIG shareholders.
Fed chairman Ben Bernanke is expected to testify before the Senate Banking Committee on Tuesday.
Officials from the city of Los Angeles said they concerned about AIG's travails because the insurer holds about $1 billion of the outstanding debt of the nation's second-largest city. Los Angeles is planning to go to market any day with a $250 million fixed-rate refunding for its convention center, and that would be harder if AIG decides to liquidate its LA bond holdings and flood the secondary market with the city's debt.
"They haven't been in contact with us," said Natalie Brill, the city's debt manager. "I only care because if my bonds are out there and there are buyers of my bonds, what are they going to buy, bonds from the secondary market or this refunding? It's a little bit complicated."
AIG held $45.7 billion in municipal debt as of June 30, according to an Aug. 6 filing with the Securities and Exchange Commission.
"It's something we're going to keep our eye on," Brill said. "I've talked to my financial advisers and their colleagues about it. They're not so concerned about that right now. The number one concern is the market and whether or not we'll have buyers of our bonds."