WASHINGTON — The Municipal Securities Rulemaking Board Thursday warned that the variable-rate demand obligation market “may be under pressure” over the next year and a half as bank credit facilities expire.
The board issued the warning in its second annual report summarizing the interest rate, trading and other data on VRDOs and auction-rate securities that were reported to it between early 2009 and April 2011.
The report found the market for VRDOs continued to shrink. The market dropped to $320 billion outstanding as of April 2011 from $339 billion in April 2010.
Total VRDO issuance accounted for just 9.0% of the municipal securities issued in 2010, the lowest percentage since 1983, the MSRB said, citing Thomson Reuters data.
Though the market is shrinking, issuers still face risks associated with expiring credit support in light of tighter credit conditions due to the financial crisis.
Over the last 18 months, issuers have been experiencing a wave of expirations of letters of credit and standby bond purchase agreements.
The issuers use LOCs and SBPAs agreements to provide liquidity to redeem bonds when necessary.
The MSRB report said LOCs and SBPAs that support $74.5 billion of outstanding VRDOs are set to expire by year-end. A year after that, around $142 billion — or 44% of all of the liquidity facilities — are set to expire, according to the board.
Moody’s Investors Service said in May that the expiration and renewal of letters of credit and SBPAs are likely to be orderly through the rest of this year. But the agency warned last October that issuers with weaker ratings, homogeneous exposure to one bank and a concentration of facility expirations face the greatest renewal challenges.
In June, Citi analysts said most bank credit facilities used to roll over VRDOs have so far been renewed.
The analysts wrote that the cost for issuers to extend LOCs is likely to rise as banks are required to hold larger amounts of liquid assets.
JPMorgan Chase, Wells Fargo Bank NA and Bank of America Merrill Lynch were the largest LOC providers in the first half of 2011, with a total of $1.7 billion of letters of credits, according to Thomson Reuters.
Sources said the market for VRDOs and credit facilities is holding up surprisingly well in light of less than favorable market conditions.
Matt Fabian, managing director with Municipal Market Advisors, said despite the growth of direct lending to issuers and fears over derivative-based products, the VRDO market “is holding together.”
“You would have expected that there would have been a more rapid shrinkage” of the market, he said.
The figure may demonstrate that some issuers “are held hostage by their interest-rate swaps,” Fabian said, referring to the fact that VRDOs often involve a swap that converts their floating rates to a synthetic fixed rate.
The cost of terminating the swaps “is so high right now” that issuers may be waiting for costs to go down to refinance into fixed rate, he said.
Another factor may be budgetary. With issuers under extreme pressure to keep costs low, VRDO financing may prove less expensive than a fix-rate refinancing.
“It’s sort of a lingering impact of the recession that is keeping more issuers in relatively more economical VRDOs for the time being,” Fabian said.
The MSRB report included data on the now-defunct auction-rate securities market.
No ARS have been issued since 2007, but the outstanding securities continue to trade.
The MSRB said ARS trading fell 7.9% in 2010 to $55.2 billion, down from $59.9 billion in 2009.
Almost all of the ARS that traded involved transactions of $1 million or more, while less than 2% of trades were for $100,000 or less.
The ARS figures may represent that a “good share” of the market is held by broker-dealers, Fabian said.