Moody’s Investors Services says an innovative new form of commercial paper could provide an attractive liquidity solution for variable-rate municipal issuers facing impending Basel III regulatory problems and is a credit positive for the sector.
JPMorgan has come up with a form of commercial paper that will allow banks to continue to support variable-rate product after the start of 2015. There is a $280 billion market for variable-rate demand bonds and similar municipal instruments that rely on bank liquidity support.
In its current form, the international banking regulatory protocol known as Basel III would make securing letters of credit much more expensive for issuers starting in 2015. Effectively, without any changes to either the protocol or variable-rate practice, that might drastically curtail municipal variable-rate issuance.
In the recent financial crisis many money funds lost confidence in some European banks that were providing support for VR products. The funds “put” the products back to the issuers and the banks, as standby bond purchasers, had to buy the debt back. That experience made bank regulators decide to strengthen bank resources to handle such stressful situations.
If the current version of Basel III were to go into effect, the regulators would require banks to have a high liquidity-coverage ratio. Specifically, Basel III would require banks to have the value of highly liquid assets divided by the potential draws on liquidity within 30 days be greater than or equal to one. That would be a “liquidity-coverage ratio” equal or greater than one.
However, to require banks to have so much liquid resources on hand would be very expensive for the banks. The banks would be likely to seek to pass their costs along to the issuers and that could materially change the economics of variable-rate demand bonds.
Starting in 2015, “we expect that banks will try to pass on these costs to municipal VRDB issuers that rely on their liquidity facilities, and if they cannot pass them, to restrict the availability of credit and liquidity support they provide to the VRDB market,” Moody’s associate analyst Coby Kutcher and vice president Thomas Jacobs wrote.
Money funds are prohibited from holding VRDBs with a put of more than 30 days. If the bonds were to continue to be offered with less than 30-day maturities after Jan. 1, 2015, they would be expensive for issuers using them. However, if they were to have greater than 30-day maturities, their main purchasers, tax-exempt money market funds, could not buy them.
There is a big wall of credit facilities expiring in the second half of 2014, said James Lansing, JPMorgan managing director of public finance. That is because the Basel III liquidity coverage provision is currently set to start on Jan. 1, 2015.
To deal with all these problems JPMorgan and some other players in the tax-exempt variable rate market have developed a new approach to VR issuance.
With the input of rating agencies, bond trustees, money market funds, issuers and the Depository Trust Corp., JPMorgan created the new callable commercial paper structure, Lansing said. The new structure is designed to alleviate the impact of Basel III, allowing banks to provide longer-dated credit facilities.
JPMorgan is planning to convert VRDBs into callable commercial paper. The paper would have a variable length of maturity, but always at least 31 days. Several days before the paper would have 30 days left to its maturity, the issuer would call the paper. New paper would be remarketed and the proceeds would be used to pay off holders of the old commercial paper.
“The variable-rate issuers are facing a big wall of renewals in 2014,” Lansing said. “The new structure allows the banks and money market funds to remain in the variable-rate market beyond then.”
JPMorgan has been the underwriter, credit support provider and dealer in two deals using the new approach. In August, the first deal converted $178 million of weekly-mode VRDBs issued by the North Texas Tollway Authority into callable commercial paper. In September, the Municipal Improvement Corporation of Los Angeles converted $130 million of its commercial paper into the callable structure.
JPMorgan had over $1 billion of orders on the NTTAissue, Lansing said.
JPMorgan is the only underwriter that has used the approach so far, according to Jacobs. However, others could use it, Lansing and Jacobs agreed.
VRDBs will continue to exist into the future because money market funds need their seven-day maturities, an investment bank professional said. If there is a demand in the market for the VRDBs, issuers will be able to lower their yield enough to cover the additional enhancement costs, he said.
Moody’s paper is titled “Innovative Liquidity Structure Is Credit Positive for Variable-Rate Demand Debt Issuers.”