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VRDNs May Not Be Viable: Bernanke

WASHINGTON - The stresses in the short-term municipal market, fueled in part by a mismatch in supply and demand for liquidity facilities, may reflect that variable-rate demand notes are not a viable financing mechanism for states and localities going forward, Federal Reserve chairman Ben Bernanke warned lawmakers last week, surprising some market participants.

"The current financial crisis has exposed the vulnerabilities of the VRDN market, raising questions about the desirability of its continuation as a significant vehicle for municipal finance," he wrote in a March 31 letter that noted many lower-rated issuers are no longer able to access the short-term market.

The Fed chairman's letter was sent in response to a request from House Financial Services Committee chairman Barney Frank, D-Mass., and 26 other lawmakers for the Fed to establish a facility to support VRDNs.

Despite his reservations, Bernanke said that if Congress wishes to provide temporary support for VRDNs, "perhaps during a transition period," it should consider legislation to authorize a government agency to create a liquidity facility to provide a backstop to commercial banks' letters of credit or standby purchase agreement.

He also said that Congress should consider establishing a federal reinsurance program to help increase the capacity of the remaining private insurers to provide bond insurance. "Such a program might help lower-rated (or even unrated) issuers access both the fixed-rate market and variable-rate markets," Bernanke wrote.

The most significant strains on municipal issuers, he said, are unremarketable VRDNs that have been put back to their liquidity providers and become "bank bonds."

"Many municipalities reportedly cannot refinance out of their bank bonds into fixed-rate debt because VRDNs are often paired with interest-rate swaps that would be quite costly to unwind because many of the swaps are now underwater," Bernanke wrote. "In addition, the swaps typically require that the municipality post collateral.

"Lower-rated issuers often cannot refinance into new VRDNs (which would not require that the swaps be unwound) because they are unable to find a bank that will provide a letter of credit," he added. "The situation for failed ARS is similar. These circumstances are causing fiscal strains for a number of municipalities."

Bernanke said that as the Fed continues to "evaluate whether the tools at its disposal are likely to be effective in addressing issues in the municipal market," "it seems unlikely" that its Term Asset-Backed Securities Loan Facility could be tapped for munis. That is partly because "municipal obligations have historically not been securitized," he said. His comment appears to reflect the fact that most municipal securities are not backed by assets, such as student loans.

The Fed chairman's letter comes as Frank is drafting legislation that would authorize the creation of a federal liquidity facility for the VRDN market as well as some type of federal reinsurance program. Frank plans to introduce the legislation and then hold hearings on it as early as May.

Frank, Rep. Michael Capuano, D-Mass., and 25 other congressmen had urged Bernanke and Treasury Secretary Tim Geithner, in a March 20 letter, to establish a temporary backstop for VRDNs as well as other short-term paper.

In a brief interview Friday, Capuano said: "It's nice to know officially that he's pretty much on the same page we are, that there is an issue and that it should be addressed."

Other supporters of a federal liquidity facility for VRDNs also said they are glad the Fed is urging Congress to consider providing support for the municipal market.

But several market participants were surprised at Bernanke's negative take on the VRDN market and said they said they hope VRDNs would continue to play an important role in state and local borrowing by allowing them to access the short-end of the yield curve for their long-term debt obligations.

Michael Decker, co-chief executive officer of the Regional Bond Dealers Association, said VRDNs are essentially the only such instrument available to municipalities since the auction-rate securities market collapsed last year.

Though some muni issuers have commercial paper programs, many do not because when the commercial paper matures and is then reissued, the reissuance can have negative tax consequences. For instance, if the commercial paper is sold by a borrower using private-activity bond volume cap, the issuer may need to find additional volume cap each time the commercial paper rolls over.

But Joseph Fichera, senior managing director and chief executive officer of Saber Partners, who agreed with Bernanke, said the short-term market historically has been reserved more for stronger credits than weaker credits. He noted, though, that even strong credits in the municipal market are not getting similar pricing for liquidity as lower-rated corporate borrowers, saying that's a disparity that has not been explained.

For example, on March 13, the A-plus-rated National Rural Utilities Cooperative Finance Corp. announced that for 50 basis points, it had formed a one-year, $1 billion revolving credit agreement with a syndicate of 12 banks to back their taxable and tax-exempt commercial paper and VRDN program. That price is much lower than the ones quoted to most municipal issuers.

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