Standard & Poor's Cites VRDO Repayment Risks

The popularity of direct loans and purchases of variable-rate debt continues to grow. But as more bank credit facilities for VR debt come due this year for municipal issuers, the alternative financing products present numerous risks that issuers must monitor, according to a new report by Standard & Poor’s.

The rating agency identified two types of repayment risk tied to variable-rate demand obligations and other debt instruments: predictable risk and event-driven risk.

“The report is really meant to give people an understanding of where we’re coming from, in terms of our thinking about these alternative financing products,” said senior director Jeffrey Previdi, one of the report’s authors. “It also gives them an understanding of what questions we’re going to ask and what information we’re going to seek to be able to figure out how we get comfortable that the risks presented by these are able to be withstood within an obligor’s current rating.”

Behind the report lies the fact that standby bond purchase agreements and letters of credit that support $130 billion of floating-rate debt are set to expire in 2011. The amount equals more than one-third of the $380 billion VRDO market, according to data from the Securities Industry and Financial Markets Association. Another $94 billion of credit support will come due for renewal in 2012.

Over the past 12 to 18 months, banks that were typically acting as providers of those credit facilities to issuers have increasingly become outright purchasers of their bonds, Previdi said. For municipalities, direct purchases by banks look attractive because, unlike LOCs and SBPAs, they aren’t subject to the restrictions that federal regulations and capital requirements impose.

“A lot of obligors are going with this direct-purchase option,” Previdi said.

Still, municipal issuers must familiarize themselves with the predictable risks associated with these products, according to Standard & Poor’s.

They include known expiration dates and subsequent termination of bank facilities, maturing commercial paper, outstanding bank lines or bank bonds that require repayment according to term-out provisions, debt to be redeemed, guarantees that have already been triggered, and upcoming mandatory tenders with known tender dates.

But VRDOs supported by LOCs and SBPAs could also be affected by event-driven repayment risks that require liquidity. Those risks include unexpected acceleration, failed remarketings forcing municipal issuer payments, interest-rate swap collateral postings, swap termination payments, and cross-default provisions under financing agreements.

“A lot of these agreements have very long lists of covenants,” Previdi said. “As we’re going through these agreements, we’re seeing what terms exist and want to talk to obligors about how well they understand them, and how they would react in the kind of instances that are ­outlined.”

The Standard & Poor’s report isn’t meant to single out direct purchases,  ­Previdi said. It acknowledged the strengths of such alternative financing products and how they provide a low-cost solution.

The report comes on the heels of one Moody’s Investors Service released on May 9. It stated that first-quarter numbers show that the resolution of LOC and SBPA expirations is likely to be orderly through the balance of the year.


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