Market Supports S&P's Crackdown On Direct Loan Transparency

Municipal investors and analysts say they welcome the heat Standard & Poor's is putting on issuers to disclose their direct loan exposure.

S&P's Mal Fallon Says Not All Direct Loans Are Created Equal

The need for more transparency has become a top concern for market participants as the use of direct loans has boomed in 2014, totaling an aggregate $117.45 billion for states and political subdivisions overseen by the Federal Deposit Insurance Corp. in the first quarter, the most the FDIC has ever reported.

"Disclosure of direct loans is extremely important to the marketplace," Adam Buchanan, sales and trading vice president at Ziegler Institutional Sales, said in an interview. "Direct loans are debt obligation and therefore have an effect on borrowers' credit profiles. There needs to be transparency. The market appreciates the message S&P sent."

S&P started its campaign for more disclosure around direct loans several years ago, and stepped up pressure on issuers in May when Steve Murphy, national head of public finance at the rating agency, sent out a letter to the estimated 24,000 issuers S&P rates, telling them their ratings will be lowered if they didn't inform S&P of their outstanding direct loans, and terms and conditions contained within the loans.

S&P re-iterated the importance of direct loan disclosure on Wednesday when it released an article called "Not All Loans Are Created Equal" discussing some of the terms and agreements in the loans it finds alarming.

"We're seeing covenants [in loans] that could trigger [the loan's] immediate acceleration," Mal Fallon, managing director at S&P, said in an interview. "Some of the risks of these covenants are more events that could lead to an acceleration. One example is failure to observe any term, covenant, or agreement, which is very broad and leaves a lot of room to call for early payment."

Other loan covenants may trigger acceleration for failure to maintain specific debt service coverage ratios or meet other financial metrics, he said.

"If issuers do not comply with one of these covenants it could put tremendous pressure on a borrowers' liquidity if failure to comply leads to rapid acceleration," Fallon said.

S&P has "some level of concern" over smaller banks getting into the direct loan business, Murphy said.

"[T]hey're not as sophisticated as the big banks and you have to be careful of the terms, you have to be careful of what you are signing because an event could lead to an impact on their outstanding rating," he said. "It's not a lot different than what we saw with swaps a few years back: less sophisticated entities get into these things and unfortunately they sign something they don't understand."

Jason Fenwick, city controller for Indiana's Anderson Redevelopment District, said in an interview that both PNC Bank and STAR Financial Bank, with which the Redevelopment District has outstanding direct loans, would be considered local banks, although "obviously PNC is not just [in Indiana]". Whether a bank is local is a factor the Redevelopment District considers when choosing who to work with, he said.

The Anderson Redevelopment District currently has $14.6 million of 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.

Gary Erskine, Anderson Market President at STAR Financial Bank said in an interview that he estimates STAR's total bank assets to be between $1.6 billion and $1.7 billion, and said that part of the reason STAR was chosen is because it is an Indiana bank.

When the Redevelopment District was deciding who to sell the direct loan to, it brought in the consulting firm O.W. Krohn and Associates, which consults with cities in Indiana and typically helps package a bond deal directly with a local bank, according to Erskine.

Otto "Buzz" Krohn, certified public accountant and executive partner at O.W. Krohn and Associates said in an interview that the primary reason it worked with STAR was because it was an Indiana bank, and that negotiations with the larger bank it originally considered for the deal "did not go well."

"Star financial understood the deal, understood the mechanic of it better than a larger bank because of their local knowledge and because they were willing to do the financing," he said. "[Star Financial] did the deal with a much simpler solution than the larger bank [originally involved] that had more internal rules and constraints as the deal evolved. Working on a more local level had much simpler terms to work out, better terms and less big corporate strings in a broad context."

Fallon said one reason municipal issuers have gotten comfortable with direct loans is because they are comfortable with their local banks, and trust that relationship. This relationship is not permanent, according to Murphy.

Bank loans can be transferred to "qualified investors," defined by SEC's Rule 501 of Regulation D as market entities ranging from bank and registered investment companies, to individuals such as a person with an income over $200,000 or even a trust with assets over $5 million whose purchases are made by a "sophisticated person."

"[I]f the loan is transferred to a large financial institution where the obligor does not have a longer term financial relationship, that institution might not be as forgiving if certain covenants are breached," Fallon said. "I am not sure if municipal issuers have to be notified if a bank sells their direct loan."

Erskine said he doesn't think Anderson Redevelopment District's loans are transferable. Krohn said he thinks STAR Financial probably has the right to trade the loan with other sophisticated investors, but that he believes they have to sign letters that this is not their intent.

S&P affirmed its long term rating of A-minus with a stable outlook in its credit report on Anderson Redevelopment District.

Matthew Fabian, managing director at Municipal Market Advisors, said in an interview that as long as loans are being transferred to other banks, it's not much of a concern, because they are still going to be overseen by federal banking regulators.

Some banks have protocols to prevent direct loans from being transferred to entities that are not larger banks.

Thomas Durkin, treasurer of the Massachusetts Water Resources Authority which has outstanding direct loans with four major banks said in an interview that he doesn't recall seeing any restrictions or any concerns with respect to loans transferability in the loans' terms and conditions.

The MWRA has three loans set to expire in three years, including $62.83 million with Citibank, $60.3 million with RBC Municipal Products, and $50 million with Bank of America. It has two loans set to expire in five years including a $55.26 million loan with Wells Fargo Municipal Capital Strategies and a $64.76 million with Bank of America, according to Durkin.

The loans with RBC and Wells Fargo can be transferred to "qualified institutional buyers" as defined in Rule 144A promulgated under the Securities Act of 1933, as amended, Durkin wrote in an emailed statement. The Citi and Bank of America loans can be transferred to QIBs and also "accredited investors" as defined in Rule 501 of Regulation D under the 1933 Act.

QIBs include hedge funds, mutual funds, and non banking entities.

Bank of America declined to comment on its loan with MWRA, and Citi and Well Fargo did not return calls for comment on their loans by press time.

"RBC has a standard practice of employing S&P guidelines when lending in the U.S. municipal sector," Jake Sigmund, managing director, RBC Capital Markets, wrote in an emailed statement.

Fallon said that in the documents he has reviewed he has not seen specific clauses preventing direct loans from being transferred to hedge funds, mutual funds and qualified issuers.

Tom Jacobs, vice president and senior credit officer at Moody's, said in a June interview that Moody's has asked for direct loans to be disclosed for a long time, and most issuers send information about their direct loans to Moody's as a matter of course.

Who the loans are transferred to "is not really something we've focused on; we expect investors to enforce rights equally," Jacobs said in an interview on Tuesday. "We don't think who an investor is will make a difference in terms of enforcing a right that's within a loan. My understanding is that one of largest lenders in this space has made it clear to me that they restrict transferability to banks that have $5 billion [or more] in capital. They do it for several reasons, one is that they like to account for these as loans rather than bonds, and limitation on liquidity is something that makes them look more like loans."

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