Liquidity Fears May Be Overblown
Climbing the wall of expiring bank guarantees on municipal debt in the coming months may not turn out to be as daunting as anticipated.
One propellant of the current hysteria over municipal credit is fear among market participants about the nearly $100 billion of letters of credit and other bank liquidity facilities on state and local government debt set to expire this year.
With the banking sector smaller, less leveraged, pickier about risk, and facing more stringent regulations on how it allocates capital, issuers especially are worried about their ability to renew these facilities, which many flocked to after the collapse of the market for auction-rate securities in 2008.
The impending wave of expirations was the subject of a recent front-page story in the Wall Street Journal and has been fodder for panels at several conferences. It is frequently explored in municipal analysts’ research reports.
As the biggest cluster of expirations nears, it is beginning to appear that banks in fact have the capacity to extend credit to most of the governments that need it.
Moreover, governments with investment-grade ratings that are unable to obtain extensions from their banks are enjoying improved access to a bond market with interest rates that are still low, and several alternatives to bank financing have begun to take off.
“There’s plenty of issuers out there that are looking for liquidity facilities and are finding them,” said Rich Raffetto, head of government banking at U.S. Bank. “We have capacity, and we have intent to continue to play a role.”
In a report last month, Citi analyst Mikhail Foux argued the fears about municipalities’ potential inability to finance their variable-rate debt — which typically requires bank backing — are “overblown.”
Renewing bank guarantees will be not be impossible — just more difficult and more expensive than during the halcyon, pre-crisis days of easy access to municipal LOCs, according to Foux.
Only in rare cases will municipalities with weak credit have trouble addressing their vulnerability to vanishing bank facilities, and have to scramble for capital, he said.
“The main players in the space still have a lot of spare capacity,” Foux said. “LOCs will be available, but at a higher price.”
Fitch Ratings is on the lookout for municipalities that hold expiring LOCs and exhibit three characteristics: a credit rating of A-minus or worse, a high percentage of debt in a variable-rate mode, and a high concentration of liquidity facilities with one or two banks.
Still, Fitch does not expect the coming wave of expirations will drag down municipal credit quality.
“We don’t anticipate widespread changes” to ratings, said Eric Friedland, group credit officer for public finance at Fitch.
The genesis of this story came in February 2008, when investors suddenly stopped bidding on municipal auction-rate securities. ARS were long-term municipal debt with interest rates that reset regularly at an auction.
Once investors stopped bidding, the $200 billion municipal ARS sector froze. Many municipalities were stuck paying double-digit penalty rates.
The immediate solution was to turn to the puttable variable-rate demand obligation. All at once, thousands of municipalities sold VRDOs to raise the cash to refund their ARS.
Municipalities sold 2,000 puttable VRDOs with $116.28 billion in par value in 2008, according to Thomson Reuters, by far a record.
By June 2009, municipalities had almost $450 billion of VRDOs outstanding, according to the Securities Industry and Financial Markets Association — amounting to 16% of all outstanding municipal debt.
Municipalities soon found out that VRDOs carried risks of their own.
Though both carry nominally long-term maturities with regularly resetting short-term interest rates, variable-rate demand obligations differ from ARS in several key respects.
The primary distinction is that VRDOs are generally puttable, meaning the investor has the right to sell them back to the issuer whenever he wants.
Because municipalities seldom have the financial flexibility to buy back their own debt at the investor’s behest, puttable VRDOs typically need a bank to promise to buy tendered paper if nobody else will. This promise comes in the form of either a letter of credit or a standby-bond purchase agreement.
Banks sold these products to municipalities in record amounts in 2008 as state and local governments flocked to VRDOs to refund ARS. New LOCs and SBPAs totaled almost $100 billion in 2008, according to Thomson Reuters.
Banks sold municipalities more LOCs in 2008 than the previous three years combined. Municipalities purchased more LOCs in the second quarter of 2008 alone than in any other full year in history.
There was a problem: while VRDOs normally mature in 25 or 30 years, the bank guarantees supporting them usually carry terms of only two or three years. That necessitates a continual rollover of bank credit each time it expires.
A municipality that allows bank credit on a puttable VRDO to expire faces the prospect of having to pay off immediately what it planned to be long-term borrowing.
The credit facilities attached to the VRDOs born in 2008 are now expiring en masse. Thousands of issuers will be trying to renew bank facilities at the same time.
The true test begins in April.
According to SIFMA, $11.5 billion of bank credit facilities on municipal VRDOs will expire in April, followed by $10.7 billion in May, and then the crest — $13.6 billion in June. More than 6,000 bank facilities expire this year and next.
The number of banks extending credit to municipalities has shrunk considerably since these facilities were first established.
Formerly active European banks, such as Dexia and the German land banks, have mostly exited the market. Consolidation in the U.S. banking sector has concentrated the supply of LOCs among a handful of names.
Though Thomson Reuters’ league tables for letter-of-credit providers are not considered complete because they fail to capture renewals, the top three writers of LOCs control more than half the market.
Last year, two banks made it into the top 10 providers by writing a single LOC each.
But the high concentration of providers does not mean renewals of expiring facilities are unattainable. It just means they cost more.
The truth is that people may be conflating higher costs with prohibitive costs.
One public finance banker estimated that during the credit bubble, a double-A rated issuer could purchase an LOC for basis points in the mid-teens. Now that same issuer might pay 50 to 75 basis points, the banker said, emphasizing that price is always specific to circumstances.
Other bankers speaking on background have argued that the surfeit of banks extending credit to state and local governments during the bubble caused banks to undercharge for LOCs.
The current rates are more reflective of an appropriate pricing for credit risk than the extremely low costs municipalities enjoyed before the credit crisis, one banker said.
Though the crush of renewal applications is yet to come, the municipality that runs out of options and is forced to allow a bank guarantee on a VRDO to expire has yet to surface.
“We’re not seeing a lot of people that can’t find credit,” said Tim Self, managing director in JPMorgan’s public finance group. JPMorgan Chase & Co. was the top provider of LOCs by a long shot last year, controlling more than a quarter of the market.
“There’s certainly enough capacity out there for the stronger names,” Self said. “Typically those strong-rated issuers are finding they’re not having too much trouble sourcing credit from the banks.”
Naturally, issuers with lower ratings have to pay more for guarantees because the number of banks willing to extend credit shrinks at lower rungs of the credit ladder. But expensive and unavailable are not synonyms.
“Perhaps it might not always be agreeable on price,” said John Hallacy, head of municipal research at Bank of America Merrill Lynch, the No. 2 writer of LOCs to municipalities. “I still think there’s fairly ample capacity. I think the bigger question is what the willingness will be to write the LOCs at a certain price point.”
Citi’s Foux pointed out that Barclays, Royal Bank of Canada, Toronto Dominion, and U.S. Bank have ramped up their municipal LOC businesses.
Some people also worry what effect the Basel III bank capital-regulation framework will have on the availability of bank credit for municipalities. The regulations would force banks to keep enough liquid assets on hand to meet every cent of their municipal guarantees, which many bankers have said will make the muni banking industry less lucrative and probably force up prices.
However, the first phase of the regulations would not be implemented until 2015, and some would not take effect until 2019.
While some banks might adjust their business in advance of the regulations, Hallacy said he has not noticed Basel III having an impact on pricing yet.
Nor are municipalities that are unable to renew bank facilities on VRDOs at prices they like out of options.
The 20-year cost of borrowing at a fixed rate for a double-A rated municipality is about 4.85%, according to Municipal Market Data. While that is much higher than 0.27% — which according to a SIFMA index is the average rate on a tax-free VRDO — it is still low enough in many cases to fix out of variable-rate debt if an issuer needs to.
“We might have a little bit of a surge in fixed-rate issuance before the termination dates,” Hallacy said.
The biggest concern is for issuers at the lower end of the credit spectrum, such as BBB+ and below, said Pierre Bogacz, managing director at HFA Partners, which advises health care issuers.
“Lower-rated hospitals and other healthcare borrowers in particular face a dearth of banks willing to renew at any price,” he said. “We expect that unless bank appetite improves, we will witness a wave of fixed rate refundings, further pushing up the [Municipal Market Data] index and tax-exempt rates in general.”
Bogacz doesn’t expect these issuers to be shut out of the fixed-rate market; it’s just a matter of how much the borrowing will cost. The most important thing is not to postpone addressing an expiring LOC, he said.
The trouble with fixing out of a VRDO is that many issuers did not use them because they wanted to pay a variable rate. They used the obligations to pay a synthetic fixed rate by inking a swap contract pledging to pay a fixed rate in exchange for a floating rate, in effect locking in a fixed rate on the VRDO.
Those swaps are now deep out of the money because the fixed rates were usually in the 4% to 5% range, and the floating rates are often based on a percentage of the London Interbank Offered Rate, which is around 0.3%.
Getting out of a swap that promises such a high fixed rate in exchange for such a low floating rate requires paying a hefty termination fee.
Several issuers have found a way around the termination fee by selling floating-rate notes, whose rates automatically reset based on an index, such as the SIFMA swap index. That way, they can refund their VRDOs and simply associate the swap with the floating-rate note.
A dozen issuers sold $1.73 billion of SIFMA-based floaters last year, according to Thomson Reuters, with the biggest coming from Massachusetts, Washington D.C., and Louisiana.