Sell Side

Lehman Swaps to Terminate

SAN FRANCISCO - Municipal bond issuers that have swaps with Lehman Brothers or related entities are preparing for termination.

Issuers, including the state of New York and a variety of others nationwide, face mandatory termination of swaps with Lehman Brothers Derivative Products Inc. today. Issuers such as San Francisco International Airport and the East Bay Municipal Utility District have swaps with Lehman Brothers Special Financing, which are subject to optional termination.

Many will owe millions to exit the trades. That may sound painful, but issuers are sighing a counterintuitive sigh of relief because they owe Lehman. They would rather owe the bankrupt company than vice versa.

Most interviewed for this story plan to exit the swaps as soon as possible.

"We're going to be replacing them as our swap counterparty" by the end of the week, said Gary Breaux, finance director at the East Bay Municipal Utility District in Oakland, which has an a swap with LBSF that's subject to optional termination due to the bankruptcy. "This transaction should be completed at no cost to the district."

That's because utility expects to find other counterparties who will pay to take over the trades. Most terminations will cost muni issuers money because local governments and hospitals entered into swaps to hedge variable-rate debt payments when fixed rates were higher. With short-term rates low, the issuers are paying more on the fixed-rate side of the trade than they're receiving on the variable-rate side.

"That's how it should work," said Breaux. "The swap market is efficient."

That assumes that the market continues to function in the face of the credit crunch and capital hoarding. The Federal Reserve and U.S. Treasury declined to bail Lehman Brothers Holdings last week, allowing it to go bankrupt and arguing the market had had plenty of time to prepare for its failure. This week's swap terminations will be the first major test of the muni market's ability to absorb the investment bank's failure in an orderly fashion.

Swap advisers say their market continues to perform.

Even with a credit crunch, issuers can find counterparties who are willing to pay to get into a trade where they collect a fixed rate that is higher than current short rates, said Craig Underwood, president of Bond Logistix LLC, a swap adviser in Los Angeles.

"We're not having any trouble finding counterparties who are willing to take over these trades," agreed Nathaniel Singer, a managing director Swap Financial Group in South Orange, N.J.

That's good news for issuers like New York.

The state will owe about $20 million for its mandatory termination today, according to Division of Budget spokesman Matthew Anderson. He said the state hadn't yet entered into replacement swap yesterday and would make the payment out of its debt reduction reserve fund.

New York has approximately $552 million of interest rate swaps outstanding with LBDP, including $215 million on personal income tax bonds, $119 million of mental health bonds, and $220 million of appropriations-backed bonds.

Issuers with optional terminations on LBSF swaps have a bit more time, and they're trying to time their terminations to coincide with new swaps, so that they don't have to tap their own budgets for the fees.

Still, they're not wasting any time. They've got lawyers and advisers combing their swap agreements for precise termination provisions and the methods for determining termination payments. Those provisions vary depending on the Lehman entity that was the counterparty. They don't want to take so long that the trade turns on them, or the market for swaps follows other markets down the road to illiquidity.

While Lehman's two swap units haven't declared bankruptcy, issuers continue to worry that they will, and they don't want to be in the position of being a creditor in a bankruptcy proceeding.

"While we owe them money now, if interest rates were to shoot back up for some reason and get to the point where they owed us money, we could lose," said Breaux, explaining his quick termination.

Kevin Kone, assistant deputy director for capital finance at San Francisco International, said the airport also has LBSF swaps that are subject to an optional termination.

"We have some time to at least think this through," he said. "If for some reason, the book is acquired by someone, we may do nothing."

Kone said he'll take a few days to formulate a plan and to see how other issuers fare in the swap market, but he won't wait long. This year has taught him to be a bit skeptical about assurances of market efficiency. He remembers how quickly access to letters of credit and liquidity dried up after issuers rushed to refinance variable-rate debt this spring.

"Think about how many people need to get out of swaps. The counterparties taking on these swaps are going to have to put out money," he said. "If municipalities want to get out of these swaps, they better get to the table first because as you wait, there's less and less money. It's just like the liquidity crunch."


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