Muni Market Participants Are Still Struggling With the Direct-Purchase Sector

Market participants are still grappling with the pros and cons of the growing direct purchase sector for tax-exempt bonds.

Direct purchases are simply loans to municipal issuers. The product was introduced roughly two years ago and has grown rapidly since: At The Bond Buyer’s 501(c)3 Super Conference in New York on Monday, direct purchases this year were estimated at $13 billion.

The loans are popular with issuers seeking to diversify away from plain-vanilla fixed-rate bonds. Variable-rate notes enhanced by liquidity support, such as a letter of credit, were previously the normal avenue, but issuers and banks have reasons to prefer direct purchases.

For issuers, a direct loan eliminates counterparty risk — the risk that a bank would be downgraded and spreads would widen on debt they offer support for. Refinancing risk is also limited to when the loan matures, rather than to the next remarketing date.

For banks, direct loans avoid the burden of regulations stemming from Basel III, which is being fully implemented in 2015. The regulations will require banks to hold Treasuries or cash-equivalents that equal the amount of liquidity facility commitments. By directly purchasing debt, banks will simply keep it on the books and won’t need to put up additional capital.

But behind their simple structure is a series of ongoing debates about how these products impact the broader market and to what extent they should be transparent.

Mary Peloquin Dodd, managing director and senior analytical leader at Standard & Poor’s, said when direct purchase agreements were first getting done a couple of years ago, issuers had the feeling that there was no acceleration risk — the risk that certain provisions will force the issuer to buy back the outstanding loan — but in fact, there is.

“What we noticed was a real difference between the haves and have-nots — the credits that were higher rated who had more liquidity understood the risks, but the lower-rated credits who didn’t have the liquidity really didn’t understand what was in those documents,” she said.

One reason for the misunderstanding is the opaqueness of the market. When banks were first doing these private deals in 2009, having the loan rated by a credit agency and communicating the details to the broader market didn’t seem relevant, according to Adam Joseph, managing director of public finance capital strategies at Wells Fargo Securities, which entered the direct lending sector earlier than most.

“We realized in the last six months or so that maybe that was a little selfish,” he said, describing an evolution in the thinking at Wells. “There were extremely valid reasons that other bondholders and market participants really needed to see certain things. There was nothing to hide — we just thought it was easier.”

Today, Joseph said, Wells encourages or even requires that the debt it purchases be rated by at least one credit agency.

“That increases market transparency,” Joseph said. “We are also now encouraging, requesting — we can’t say advising —  that our issuer clients post the covenant agreements and indentures on EMMA.”

The difficulty there is that Wells isn’t playing the role of remarketing agent or underwriter, so it has no official standing to require issuers make those documents available. But bankers now feel the market has a right to know what’s going on, and issuers have in general been receptive to making transactions more transparent.

“We’re telling our issuers we think this is relevant to other participants,” Joseph said.

“Once investors see that these deals don’t have anything in them that’s scarier than a letter of credit, they’ll be comfortable.”

Another still-evolving front is the pricing structure.

When an issuer is buying a liquidity wrap, it might consider paying more for a highly rated bank to avoid problems relating to reset risk. But with a loan, the issuer need not be concerned with the bank’s rating.

That creates competition, so issuers should be able to negotiate for better deals, according to Nat Singer, managing director at Swap Financial.

“If you have a hungry bank, you can get concessions on the covenants which actually makes the direct purchase a better deal than the traditional LOC on a VRDN,” Singer said. “For the bond counsel out there: don’t be shy. Mark up the documents and see how banks react.”

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