Statistics on letter-of-credit issuance to municipalities last year indicate the municipal credit market is in dire trouble. But the statistics only tell part of the story.
According to the numbers, banks wrote just $11.79 billion of letters of credit guaranteeing municipal debt in 2010. The last time banks wrote so few LOCs was 1999. The latest figure represents a 49% drop from 2009 and an 84% plunge from 2008, according to Thomson Reuters.
Former stalwarts of the market like Royal Bank of Canada and Bank of New York Mellon disappeared from the LOC league tables. Nine of the top 10 municipal LOC banks in 2009 curtailed their business in 2010.
Why is this bad news? The purported evaporation of bank credit for municipalities coincides with an impending crush of demand for such credit. Nearly $140 billion of LOCs and standby bond purchase agreements supporting municipal variable-rate facilities are scheduled to expire this year and next, according to the Securities Industry and Financial Markets Association. A $45 billion knot of liquidity facility expirations is coming from April to July this year.
Municipalities will either need to renew these facilities with banks that are currently doing very little business with state and local governments, or flood the bond market with fixed-rate debt to raise the proceeds to refund their facilities.
Fortunately for the municipal market, the numbers only show LOCs written on new debt; they ignore renewals of existing facilities.
This omission is not just a footnote: by all accounts, since issuance of new variable-rate debt has slowed to a crawl, most of the action in the municipal letter-of-credit sector is in renewals. Any LOC issuance figure that excludes renewals is not coming close to telling the whole story.
Bank of America Merrill Lynch reckons LOC issuance last year was closer to $40 billion, when renewals are included.
“I would say it’s still fairly good with the major banks,” said John Hallacy, head of municipal research at Bank of America Merrill Lynch, in reference to bank capacity for extending credit to municipal governments.
Make no mistake: the availability of LOCs for municipalities is far tighter than it was in 2008, when banks wrote $71.78 billion of them on top of $28.10 billion of SBPAs.
Municipalities were refunding their frozen auction-rate securities in droves that year, and at that time banks were all too happy to guarantee municipal debt for a handful of basis points.
Since then, consolidation in the U.S. banking sector, the withdrawal from the market of many of the European banks, and a broad downward migration of credit ratings have rendered the municipal LOC space essentially an oligopoly.
The top two municipal LOC banks — JPMorgan and Bank of America — controlled more than 45% of the market last year, according to Thomson Reuters figures. Depfa Bank and Mizuho Holdings both landed in the league table’s top 10 by writing a single LOC each.
But while municipalities will have to pay more for LOCs now, their availability is not as constrained as the Thomson tables show.
“We have remained just as active as we have been in prior years,” said Rich Raffetto, head of government banking at U.S. Bank.
U.S. Bank fell to the 15th spot in the LOC league tables last year from second place the year before, which Raffetto assures is because the bank’s activity is mostly in renewals.
“Our pipeline volume has moved more toward replacement liquidity facilities than new-issue activity,” he said. “That’s where we’ve seen a lot of opportunity and that’s where we’ve spent a lot of our resources. Our bank remains very busy in the market, although you’re not seeing us quite as active in the new-issue market because [it] continues to be very focused on fixed-rate financings.”
Indeed, municipalities last year sold just $25 billion of puttable variable-rate demand obligations — the debt structure that requires bank backing. That was the lowest total since 1996.
Municipalities have shifted away from variable-rate borrowing and almost entirely to fixed-rate borrowing, in part because fixed rates are low and variable-rate facilities carry headaches like interest rate swaps and the need to regularly roll over bank credit. Last year, more than 90% of municipal borrowing was fixed rate, the highest share since 1983.
Municipalities that fail to line up a renewal for a bank facility will most likely have to sell fixed-rate bonds to refund the variable-rate facility.
Depending on how well-regarded an issuer’s credit is, fixing out of a VRDO could prove costly, said Pierre Bogacz, managing director at HFA Partners, which advises health care issuers.
“It’s not so much access but at what price,” he said. “The bigger problem is what that means in terms of cost of debt and debt-service coverage ratio.”
The most important thing is for municipalities not to postpone addressing an expiring facility, Bogacz said. Issuers who wait for the last minute might have to scramble.