Buy Side

Floating-Rate Debt Faces a Liquidity Issue

Municipalities with floating-rate debt, especially those with lower bond ratings, are likely to face high costs to renew their liquidity facilities this year and next — if they can obtain them at all.

More than $200 billion of state and local governments’ credit ­facilities — a term chiefly used to describe bank letters of credit and standby purchase agreements — are set to expire in 2010 and 2011, according to a ­Standard & Poor’s estimate based on ­Bloomberg data.

The unusual volume of expirations comes courtesy of the implosion of the auction-rate securities market in February 2008, which prompted hundreds of government bodies to flock to variable-rate debt products that typically require credit backing from a bank to appeal to investors in the short-term market.

These facilities usually expire after anywhere from one to three years, meaning a rash of issuers who purchased letters of credit in 2008 are facing expiration sometime in the next 18 months.

Expiration is normally no big deal. Upon expiration, a municipality typically negotiates a renewal with its bank. What is different this time around is the financial crisis damaged many banks’ credit ratings and chased others out of the market, constraining the banking sector’s capacity to offer credit support for governmental debt.

The question now is, how much of that $200 billion in expired credit facilities will be able to secure renewal? And how much will need to be financed elsewhere?

Standard & Poor’s analysts in a report earlier this month said the higher cost of liquidity support, and in some cases the inability to find support at all, could increase some municipalities’ cost of repaying debt and pose budget or liquidity pressures, ultimately leading to credit deterioration.

Analysts at JPMorgan expect about $30 billion of the $101 billion in expirations in 2011 are likely to have trouble renewing with their existing bank.

“There are a significant amount of credit facilities that are coming up for renewal in 2011,” said Tim Self, managing director in JPMorgan’s public finance group. “Overall I believe it’s going to stretch things, but I think, at the right pricing level, there is enough bank capacity out there.”

While LOC-backed bonds are not an overwhelming slice of a $2.8 trillion municipal bond market with $400 billion in new borrowing annually, issuers that cannot renew or find a new bank willing to offer credit support will have to float fixed-rate bonds to redeem their variable-rate debt, or figure out some other way to avoid the punitive costs of letting a credit facility on variable-rate debt expire.

Until 2008, local governments commonly raised money by issuing auction-rate securities, which carried interest rates that reset regularly at an auction. The catch came if nobody bid. In the event of a failed auction, the holder of the ARS was stuck with them, and the municipality was forced to pay the investor a penalty rate, which was sometimes in the high teens.

In February 2008, auctions in the $200 billion ARS market failed in droves. To avoid paying penalty rates, many municipalities bought back their ARS from investors. This generally required municipalities to borrow money to raise enough cash to redeem the securities.

A typical solution was to sell variable-rate debt obligations. VRDOs are similar to ARS in that both normally pay short-term interest rates because they reset regularly. The difference is that if nobody wants a VRDO, the holder in most cases can force the municipality to buy it back.

Because few municipalities have the ­financial flexibility to buy back debt when   investors opt for them to do so, VRDOs normally require a bank to step in and buy the bond if nobody else will. That means a municipality selling a VRDO usually has to pay a bank to provide liquidity ­backing.

Municipal governments sold variable-rate debt at a mesmerizing pace in 2008. Otherwise a slow year for bond issuance thanks to massive credit shocks in the fourth quarter, 2008 saw more than $120 billion in new issuance of variable-rate debt, according to Thomson Reuters, easily a record and more than double the previous year.

The issuance, fueled by the need to redeem ARS, sparked an attendant mushrooming in banks’ sales of letters of credit to municipalities.

Banks sold municipalities $71.52 billion in letters of credit in 2008, again a record and more than triple the previous year. Municipalities bought more letters of credit in the second quarter of 2008 alone than they bought in all of 2007.

Standby-purchase agreements also experienced a spike, to $28 billion in 2008 from $17.7 billion in 2007.

Many of the banks that sold these facilities are in no position to renew them. The list of letter of credit providers in 2008 includes a hodgepodge of German and French banks, many of which would be unfamiliar to most Americans.

Dexia Group, for example, was the fourth-biggest letter of credit provider to municipalities in 2008. It has exited the market. Other banks prominent in the industry in 2008 that have since curtailed or closed their municipal credit facilities business include Allied Irish Banks, UBS, and Landesbank Baden-Wurttemberg.

Last year, four banks — JPMorgan, U.S. Bank, Bank of America, and Wells Fargo — wrote 60% of the letters of credit sold to municipalities.

Rich Raffetto, who heads government banking at U.S. Bank, said for most localities the bank liquidity will be there, it is just a matter of how much it will cost and how to structure the facility.

Raffetto pointed out that new issuance of VRDOs has been very light for more than a year, meaning the banking sector has capacity to extend existing facilities.

Banks’ appetite to provide liquidity support to lower-grade issuers, though, is minimal in the current market, he said.

“Banks, because they haven’t had to go down the credit spectrum, are staying in the investment-grade to high-investment-grade sector,” he said. “It’s the low-investment-grade and below-investment-grade issuers still facing a conundrum of little availability in the banking sector. ... If they’re below investment grade, I think they’re having a tough time.”

U.S. Bank has been hearing from ­issuers who have letters of credit with banks ­unlikely to renew, Raffetto said.

Having your credit facility expire is an unenviable fate. Most credit facilities ­embed provisions governing what happens if the bank is forced to buy the bonds because nobody else will.

In many cases, the municipality is forced to repay the debt to the bank at an accelerated pace, often with penalties.

According to the Standard & Poor’s ­report, issuers have utilized a number of new structures in anticipation of expired credit facilities. These include bond ­anticipation notes and extendable ­commercial paper, or other structures that eliminate the bank as the source of back-up ­liquidity.

Self said some issuers have already ­begun selling fixed-rate bonds to raise the cash to buy back their VRDOs.

The California Department of Water Resources, for instance, floated nearly $3 billion in fixed-rate bonds this month, in large part to redeem $2.68 billion in ­variable-rate debt.

The utility said it wanted to shield itself from the “uncertainty and expense” of  variable-rate debt. After this deal, the DWR estimated $2 billion of its $8.4 billion in debt would pay a variable rate.


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