Attorneys Weigh Risks to Muni Market

WASHINGTON — With lawmakers in Washington still deadlocked over a debt-ceiling solution, public finance attorneys are evaluating what the effects of a U.S. downgrade would be on the municipal bond market.

The lawyers say the potential for a downgrade of the United States’ triple-A rating poses various risks to the municipal market. Specifically, bond attorneys said they are checking bond covenants associated with advance refunding escrow accounts. Debt service for advance refunded bonds is paid out of escrow accounts typically funded with U.S. Treasury securities.

Attorneys also said they are alerting investors about downgrade risks to housing bonds backed by mortgages with a federal Ginnie Mae guarantee. Additionally, sources said Build America Bond subsidy payments may get delayed if the Treasury Department has more bills to pay than funds available.

As of Wednesday afternoon, Congress was stuck with two spending reduction plans and there was little sign of a compromise. The Congressional Budget Office said both plans, one from Democrats in the Senate and the other from Republicans in the House, will reduce spending by less than lawmakers had hoped for.

In most cases, attorneys said issuers’ advance refunding escrow accounts must hold “direct obligations” from the federal government, but the agreements do not mention that the securities must be rated triple-A.

“It’s much more common that it is a 'direct obligation’ of the federal government” in escrow account covenants, said Perry Israel, an attorney in Sacramento.

A more complicated question arises if the federal government actually defaults on Treasury obligations. “There remains a contingent obligation that goes back to the issuer in many cases,” meaning issuers who have defeased outstanding bonds using escrowed Treasuries may be required to make investors whole, Israel said.

In May, the Treasury closed the window for state and local government securities to help preserve its capacity to borrow. SLGS are Treasury securities specifically structured to be used in escrow accounts for advance refunded munis.

Since the cutoff in SLGS sales, issuers have relied on purchasing Treasuries in the open market for escrow accounts. This has added complexity and cost for issuers managing advance refunding escrow accounts, sources say.

Issuers are also worrying a federal downgrade will trigger a downgrade to Ginnie Mae, which provides a full faith and credit pledge from the U.S. government on the mortgages it guarantees.

Bonds that are backed by mortgages with Federal Housing Administration guarantees are also at risk of a downgrade, sources said.

In Florida, bond documents for Ginnie Mae-backed housing bonds have included a credit risk statement stemming from the federal government downgrade potential.

JoLinda Herring, an attorney with Bryant Miller Olive PA in Miami, said the firm’s housing bond documents have disclosed the federal downgrade alert since May.

A downgrade to Ginnie Mae “would obviously trigger a downgrade” to housing bonds backed by Ginnie-supported mortgages, she said.

Moody’s Investors Service said earlier this month that housing bond credits that rely on “federally appropriated debt programs would be in danger, and downgrades of these programs would be inevitable.”

Issuers are also anxious about BAB subsidy payments. Before the federal stimulus-related BAB program ended at the close of 2010, state and local governments sold billions of dollars of the taxable bonds that have interest payments subsidized by the federal government.

Those governments faced similar concerns about BAB payment uncertainty three months ago, when the federal government narrowly averted a shutdown over the fiscal 2011 budget. To play it safe, many issuers are keeping enough cash on reserve to make a full debt-service payment in case a federal subsidy payment gets delayed.

Michael Roshar, a partner with Quarles & Brady LLP in Milwaukee, said in Wisconsin, most issuers appropriate the gross amount of debt service for BABs and when the federal subsidy arrives, the money “stays in the loop for debt service.”

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