Concerns Raised on VRDOs

Issuers and industry officials yesterday said they are disconcerted about a "disconnect" between the high rates issuers are paying for variable-rate demand obligations that have become bank bonds, and the low rates banks are receiving on loans from the Federal Reserve after using the bonds for collateral.

They voiced their concerns at the Securities Industry and Financial Markets Association's Municipal Bond Summit in New York as dealers said they are coming out with new products to address the VRDO problem for issuers.

Bank bonds are variable-rate demand bonds that have liquidity facilities - standby bond purchase agreements or letters of credit - from banks. The financial crisis has made it difficult, if not impossible for issuers to remarket these bonds. As a result, the bonds are put to the banks, with issuers forced to pay very high penalty rates and pay back the debt on an accelerated basis to the banks. To finance the puts, the banks are using the bonds as collateral for low-interest loans from the Federal Reserve.

"It is quite disconcerting when we're generally aware [that] when we draw on a bank, the bank is generally able to finance that purchase at the Fed," Nancy Feldman, director of the New Jersey office of public finance, said during a panel on the muni market. "And so for us to be paying for quite eye-popping rates at a time where that can be financed at a much lower rate seems to be somewhat of a disconnect."

In an interview, Feldman cautioned she was not saying that she now believes the risks of issuing VRDOs to access lower borrowing rates at the short end of the yield curve outweighs issuing costlier fixed-rate debt. Rather, she was merely commenting on market conditions, not complaining about them, she said.

"Clearly the banks have the upper hand," she said, adding that her state has still saved money over the long term by issuing variable-rate debt instead of issuing all debt on a fixed-rate basis.

But several industry sources, who asked not to be identified, said the banks are making a "killing" by charging municipal issuers as much as 10 times more for liquidity facilities today than they did before the credit crisis and while access to liquidity for corporations remains comparatively cheap.

Though there is no publicly available data on the volume of VRDOs that have become bank bonds, industry officials estimate that they comprise 5% to 10% of the roughly $400 billion of outstanding VRDOs. One industry official at yesterday's SIFMA conference speculated that the actual figure is probably on the low end of that estimate, somewhere close to $20 billion. But that estimate could not be confirmed, and the Fed does not release statistics on the amount of bank bonds used as collateral for loans to its member banks.

Some market participants said this discrepancy exists despite commercial banks' risk-capital reserve requirements that are far lower for the loans or credit facilities they provide public-sector entities than for those provided to corporations.

Michael Decker, co-chief executive officer of the Regional Bond Dealers Association, who did not attend the conference, said that Feldman's remarks reflect the need for the Fed to provide liquidity facilities for the municipal market, which would be authorized by legislation introduced last month in the House Financial Services Committee.

If the legislation is enacted, issuers would be able to purchase Fed-financed liquidity facilities to replace the troubled existing ones provided by banks that have been downgraded by the rating agencies. Though the underlying credits on the VRDOs have not changed, the downgrades to the banks' ratings have forced money market funds to sell them because they no longer comply with risk requirements established by the Securities and Exchange Commission.

"If the Fed becomes the liquidity provider, demand for these bonds will return," Decker said.

The remarks come as Citi has come out with a new product, tentatively called windows variable-rate demand bonds, or WVRDBs, that would allow highly rated issuers to sell variable-rate securities without credit enhancement. On May 28, the product received a so-called no-action letter under which the SEC's enforcement division agreed not to take any enforcement action against money market funds that purchase them.

The no-action letter came the same day attorneys for Citi put in a formal request to the SEC that describes the system, which seeks to reduce the exposure of funds to banks and other financial institutions. It appears to give issuers 13 months to repay or refinance the product if it becomes un-remarketable. SIFMA is in the early stages of drafting documents that would make the system uniform across the industry, the group's officials said.

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