Sell Side

Bear Gets Double Downgrade

Downgrades and larger troubles at Bear, Stearns & Co. call into question the creditworthiness of the bank as a swap counterparty for municipal issuers, as well as its ability to continue as one of the top10 most active underwriters in the market.

The corporate rating of Bear Stearns was downgraded by two of the three rating agencies Friday, after liquidity concerns drove the investment bank to secure emergency funding from JPMorgan and the Federal Reserve Bank of New York.

Standard & Poor's downgraded the top-five Wall Street bank to BBB from A, while Moody's Investors Service downgraded the firm to Baa1 from A2. Both ratings remain on review for further downgrade.

In 2007, Bear Stearns was the eigth-ranked senior manager in the tax-exempt market, involved in 138 issues worth a total of $24.8 billion, according to Thomson Financial. So far in 2008, Bear has been the fifth-ranked senior manager, leading 15 deals for a total of $3.9 billion.

Due to the widespread influence as an underwriter, Bear Stearns troubles have caused concern for the state of California, as two large deals in which Bear served as an underwriter - a $1 billion auction rate security refunding for the CaliforniaDepartment of Water Resources, as well as a $302.5 million deal for the State Public Works Board - are not yet closed. California has yet to receive the proceeds of the sale from the bank.

The DWR deal closes on March 19 and the public works deal closes March 26, on which dates Bear Stearns will owe the state two large amounts. To protect themselves, California officials have asked for an assurance in writing that the funds will be delivered.

"Given the financial difficulties, we want their assurance in writing that they are going to perform pursuant to the agreement they signed with the state," said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer.

At the end of the day Friday Bear Stearns chief financial officer Samuel Molinaro addressed the state's concern in a letter.

"The secured loan facility provided by JPMorgan Chase & Co. which we announced this morning is available to assure that Bear Stearns has sufficient liquidity to continue normal operations, fulfill its commitments and meet all obligations, including its obligations under the bond purchase agreements with the state of California," Molinaro wrote.

The trouble started early last week, when rumors began to spread that the bank was having liquidity problems. This led the Federal Reserve to pledge additional liquidity measures under a program that will not be up and running until later this month, said Dick Bove, an analyst at Punk, Ziegler & Co. Since Bear's troubles were more urgent, JPMorgan stepped into the gap and provided a secured loan facility for a period of 28 days which will allow Bear to access liquidity as it needs it.

Bear Stearns executives held a brief conference call Friday to answer a handful of questions, and have moved up the release of their first-quarter earnings to Monday. The bank did not return calls for comment by press time.

The liquidity concerns led to the downgrades, which has a direct impact on the municipal market because of Bear's role in municipal swaps and derivatives - deals in which the firm often serves as counterparties for municipal issuers.

In these agreements, conditions are defined under which the swap can be terminated or in which issuers or banks can demand collateral posting. Conditions that are tied directly to the ratings of the issuer, or in this case, the bank.

"Most of the remedies are triggered off ratings," said Craig Underwood, president of Bond Logistix LLC. "Every document has different thresholds, but usually you have a collateral posting requirement if they are out of the money on a swap."

In many of the swap agreements, the thresholds for requiring the counterparty to post collateral or terminate the swap are low, triple-B or lower, according to sources. But the downgrade places the ratings right smack in the middle of this range.

As the rating falls farther from the level where it was when the agreement was signed, more and more collateral is required to be posted. At some rating level, which might have been reached for some issuers with the recent downgrade, the swap can be terminated and whoever is out of the money would need to pay the counterparty, Underwood said.

However, in many cases Bear Stearns is not on the hook, because interest rates have fallen since many of the swaps were structured, said Brian Mayhew, chief financial officer at the Bay Area Toll Authority.

"In technical terms they will say you have no exposure to them because they don't owe you money," Mayhew said. "But a layman would say, oh my god if this thing is terminated I owe them money."

In most cases, Mayhew and others said issuers will not look to terminate the swap because they still want the economic benefits that led them to enter into the swap in the first place. In some cases, the swap can be transferred to another counterparty and kept intact.

"I think the municipalities are looking to realize economics," said Evan Rourke, a portfolio manager at MD Sass. "In my opinion [issuers] are not excited about taking collateral or having their transactions terminated, so from their side they would be relatively flexible."

However, Friday's events serve as a reminder that the counterparty relationship is rife with risk. Because of this, Standard & Poor's analysts have long counseled issuers to write stringent swap regulations into their agreements.

"As part of our debt derivative profile we penalize issuers for having counterparties that are rated low and have rating triggers that are below triple-B in absence of collateral postings by that counterparty," said Peter Block, an analyst at Standard & Poor's.

Stringent regulations have insulated at least one issuer from the current turmoil. At the Bay Area Toll Authority, Mayhew has prescribed specific requirements that must be met by the counterparty. Bear Stearns did not meet the conditions, Mayhew said.

So the authority has no direct exposure to Bear as a counterparty, though two deals are intermediated through Ambac Assurance Corp., Mayhew said. The authority also writes clauses into their documents that ensure a counterparty cannot be forced to surrender a termination payment in the event of default or downgrade.

"It cost us a couple more basis points but it is for our organization's protection and peace of mind," Mayhew said.


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