Issuers who have outstanding direct loans said the alternative to traditional municipal bonds is even more attractive now than at the beginning of 2014.
The loans are more appealing because the year's low volume has made the banks buying the direct loans hungrier for debt and more willing to offer issuers a cheaper deal.
"You get a better interest rate with a bank purchase," Jason Fenwick, city controller for Indiana's Anderson Redevelopment District, said in an interview.
Municipalities like Anderson are starting to respond to an April letter from Standard & Poor's to about 24,000 issuers, telling them to disclose their direct loans or risk losing their credit ratings.
Direct loans are an alternative financing whereby issuers choose to raise capital by selling municipal securities to a select number of investors instead of making the bonds available to the public.
Steve Murphy, national head of public finance at the rating agency, said S&P has changed some of its ratings based on some of the documents and terms and conditions of direct loans disclosed so far, initiated caps on certain ratings based on risk exposure, and removed a few ratings. He declined to provide further details.
The Anderson Redevelopment District currently has $14.6 million privately placed debt outstanding, according to an S&P credit profile report obtained by The Bond Buyer. This debt includes $11 million of refunding bonds and lease obligations sold to PNC Bank in 2012 and $5.6 million in new tax-increment revenue bonds sold to Star Financial Bank under three direct purchase agreements in 2013.
"We certainly are evaluating our options throughout the year, and earlier this year capital markets were more competitive, and now the direct purchase market is more competitive than capital markets," Fenwick said. "If we were [issuing debt we] might be heading down [the direct loan] path again."
Direct loan purchases have spiked in recent years, increasing as variable-rate demand bond issuance has declined, S&P wrote in a report in March. Part of direct loans' appeal is that they are cheaper than VRDOs since they do not require a bond counsel or require as much regulatory disclosure as VRDOs, Matt Fabian, managing director at Municipal Market Advisors, said in a May interview. MMA estimated in an April 2014 report that direct loans accounted for $55 billion of municipal volume in 2013.
On May 6, S&P sent out a letter to the issuers it rates seeking disclosure of their direct loans.
Even with the additional reporting requirement from S&P, some issuers say the continuing lack of supply has made direct loans even more profitable than they were at the beginning of 2014, and will turn to direct loans if they plan on issuing debt in the future.
"I think typically the decision usually involves what can be cheaper in terms of lower interest rates, that can vary at times," Fenwick said. "Now the bank rates are lower and costs are lower than doing a public offering."
Issuance this year has totaled $149 billion as of June 30 compared to $179 billion for the same period in 2013, according to data provided by The Bond Buyer and Ipreo.
Joseph Resta, executive director of the Delaware River Joint Toll Bridge Commission, Pennsylvania, wrote in an emailed statement that cost factored into the DRJTBC's decision to use direct loans. In 2011 the Commission converted bonds in VDRO mode into two direct purchases totaling $69.825 million each with Wells Fargo and JPMorgan respectively, according to a spokesman for the Commission. The debt was originally sold in 2007 as auction rate securities, before being converted into VDRO mode.
"Based on evaluation of the responses, the Commission entered into a direct purchase structure with Wells Fargo and JPMorgan for the 2007B bonds in 2011 with a three-year term in order to obtain the lowest possible cost and minimize remarketing risk," Resta wrote. "The performance of the 2007B bonds in the direct purchase mode has been significantly more favorable than the performance in either the Variable Rate Demand Bond mode or the Auction Rate Securities mode."
Adam Buchanan, vice president of institutional sales and trading at Zeigler said he does not see direct loans becoming less attractive in the current market environment.
"The benefit of direct lending has been twofold: its cheap capital and ease of execution," he said. "The caveat to that is you have to be very diligent in understanding the terms of the direct loan as a borrower."
Murphy said that S&P has gotten a "really good" response to its May letter, but that there are some nuances in the recently disclosed direct loans' terms and conditions he finds concerning. One involves the acceleration clauses contained in many direct loans.
"One of the things the banks will say to us when we talk about [the acceleration clause] is that we have a relationship with x,y,z issuer and we would never accelerate even though we can," he said. "Even if the acceleration conditions are met, we would not accelerate because of that relationship."
Buchanan said that in stress scenarios documents are what will govern the status of these transactions.
"I disagree with [banks saying they won't accelerate] 100 percent," he said. "Proof of this is how the banks reacted during the implosion of the auction-rate market."
Fenwick said that he "was not around" when Anderson Redevelopment District's two bank loans recently disclosed to S&P were done.
"If I were looking to do a new agreement, I would not want an acceleration clause in there. It would be a concern," he said.
Tim Blake, managing director at Moody's Investors Service, said in the acceleration clauses Moody's sees in direct loans are very much parallel to the ones it sees in support facilities or VRDOs.
Resta pointed out that with its 2011 direct loans to JPMorgan and Wells Fargo, the Commission would have "been at similar risk in the VDRO mode from 2008 through 2011, without in fact the 180-day period that the Commission has to cure in the current agreement."
The DWTBA's two January 2014 direct loans with Wells Fargo that total $127.7 million contain an acceleration clause, according to S&P's May 7 credit report on the municipality. S&P wrote that the municipality can manage the two loans' acceleration risk at its current rating level.
A bank engaged in direct loans also said there are typically additional restrictions around the acceleration clauses.
The bank stressed in an emailed statement that it limits itself contractually to selling the direct purchase bonds to other banks with large capital bases, thus preventing the bonds from being held by hedge funds or other non-bank entities.
S&P also raised concerns about the loans' transferability.
"There is something in all of these loans that talks about transferability, and they say that these loans can be transferred to a qualified investor," Murphy said.
Murphy said a "qualified investor" is a legal term, defined in SEC's Rule 501 of Regulation D. It refers to banks, insurance companies, registered investment companies, or employment benefit companies, which Murphy said aren't a concern.
"Then you get down to a person with their spouse with a joint net worth of over $1 million, a person with income of over $200,000, or joint [income] over $300,000, and trust with assets of over $5 million whose purchases are made by 'a sophisticated person'," he said. "The point is as you go down this list, the higher the number the more likely it looks like those types could have liquidity crunches and if they hold this as an asset could accelerate this."
Murphy said this undercuts the banks assertion that they will not use the acceleration clause because they have a relationship with the issuer.
Moody's Investors Service also notes that issuers' ratings evaluate whether the issuer would have a liquidity issue if the acceleration clause was triggered, and is not a rating of the loan holders' finances.
"We consider [the direct loan's risk] the same if held by qualified individual [or a bank]," said Tom Jacobs, vice president and senior credit officer at Moody's. "If it is triggered or tripped, a lender is a lender and an acceleration right is an acceleration right. If it's there and there's limited headroom, [the acceleration clause] will put pressure on rating regardless of who holds the debt."
It's hard to say whether issuers are complying with S&P's disclosure requirements, Murphy said.
"It's hard to know what percent we're capturing because we can only deal with what we get, Murphy said. "Whatever else is out there we will eventually see on a balance sheet, or we will find out eventually."
