After New Jersey refinanced or converted all of its $3.4 billion of auction-rate debt earlier this year, state Treasury officials decided to evaluate whether the state would have been better off having sold fixed-rated bonds instead.
They found that despite the recent spike in auction-rate costs after the market for such securities imploded earlier this year, New Jersey still came out ahead. The state actually generated a net savings of over $40 million by issuing auction-rate securities over the past few years.
State officials and others say the net savings are not a big surprise as short-term rates over 20 years or more tend to offer better costs than fixed rate.
"One very important thing is, even in this environment, if you look at a 20-plus-year bond issue, there has not been a 20-year period where short-term rates have been higher than long-term rates," said the state's director of public finance, Nancy Feldman. "So it's something that you just have to consider."
Short-term auction rates gave issuers lower interest rates until mid-February, when auctions began to fail.
Typically, the rates on auction-rate securities reset every week or every month through a Dutch auction bidding process. If investors looking to unload their ARS cannot find enough buyers at auction, which means the auction has failed, the issuer must pay a higher interest rate to investors.
In the past, the large Wall Street investment banks, serving as remarketing agents on the auctions, would buy any unsold securities to make the transaction whole, yet by mid-February, banks began to scale back due their losses in the sub-prime mortgage market.
Exiting the auction-rate market has forced issuers to take on additional interest rate costs and added issuance fees to refinance the debt, but for states at least, those stresses have not been dramatic enough to bring about downgrades.
"On a total basis, it's not an overwhelming part of anyone's debt portfolio because [states] were able to move pretty swiftly to restructure," said Standard & Poor's analyst Robin Prunty. "It wasn't anything that had any negative impact on state credit."
Issuing auction-rate bonds during the period from 2003 through 2007 proved to be $103.1 million cheaper for New Jersey compared to fixed rates. Additional interest costs due to failures in the auction-rate market, costs of issuance to refinance or convert the debt, and swap termination and letter of credit fees sliced those savings down to $41.2 million, according to the report.
On $3.4 billion of ARS, the state paid $21.5 million of total additional interest costs when rates began to spike in mid-February. Cost of issuance fees to exit the troublesome market total $15.96 million and swap terminations and LOCs total $24.3 million.
Removing the debt from the auction-rate market meant refinancing to fixed-rate mode or converting to variable-rate demand obligations. The decision, in part, depended on the credit quality of the insurance already attached to the bonds.
New Jersey's debt carried insurance from a variety of insurers and when rating downgrades swept through the industry, that led to liquidity problems for the affected bonds.
"If the bond insurers' credit quality was still triple-A and market-acceptable, and for those that we could, rather than buying additional credit enhancement, we used the credit enhancement we had," Feldman said. "In the case of those where we refunded, either the credit enhancement was no longer useful - meaning the credit enhancement or the bond insurer had been downgraded - or it was more expedient to do a refunding because the current refundings on the bonds are callable at par, and you don't have to do any of the complex things associated with an advanced refunding."
The affected debt includes $2.3 billion of New Jersey Economic Development Authority school facilities construction bonds, $345 million of NJEDA light-rail transit system project debt, $62.7 million of taxable NJEDA business employment incentive program bonds, $180.9 million of New Jersey Building Authority state building revenue debt, $345 million of New Jersey Transportation Trust Fund Authority bonds, and $182 million of taxable New Jersey Sports and Exposition Authority state contract bonds.
State officials refinanced the NJEDA school construction bonds first in May, followed by the NJSEA bonds as securities with the most potential cost to the state were addressed before other series, according to Feldman.
In looking at the different series, the NJEDA school construction bonds generated the most savings for New Jersey, $69.8 million, along with the highest total added interest costs of $12.5 million, and the highest costs of issuance, $8 million. LOC costs of $2.3 million brought the state a net savings of $47 million on the debt, according to the report.
Two series actually cost the state overall as the taxable NJSEA auction-rate bonds generated a negative net savings of $14 million due to an $11.5 million swap termination fee and $2.5 million of issuance fees.
In addition, the auction rate on the taxable NJEDA business employment bonds actually cost the state $1.14 million more from October 2004 through Dec. 31, 2007, than if the state had issued the securities in fixed-rate mode. Add on the additional interest rate costs during the failures at auction, issuance fees, and a $1.4 million swap termination, and New Jersey's total loss on those securities is $4.3 million.
While the state no longer has ARS within its debt portfolio, one lingering issue revolves around five floating-to-fixed-rate derivatives for a notional amount of $345 million that are attached to the NJTTFA bonds. The swaps have a total mark-to-market termination cost of $6.2 million as of Sept. 30, Feldman said.
With those derivatives, the authority pays fixed rates ranging from 3.63% to 3.675% and receives 67% of one week, or on two swaps, one month of the London Interbank Offered Rate from Goldman Sachs Mitsui Marine Derivative Products LP, according to the state's last official statement.
Officials are looking at entering into reverse swap agreements that would offset the existing derivatives, although the authority also approved terminating the swaps, in order for officials to end the swaps, if need be. Feldman and her staff are still watching the market in order to make a decision.
"The authorization from the board authorized a number of different things, including termination," Feldman said. "But because the market is so volatile at this moment, it's better not to make a decision in this market when things are not normal."
As a result of refinancing and converting its ARS, New Jersey's total variable-rate debt now accounts for 9% of its $32 billion of outstanding debt, down from 14% at the end of 2007. Feldman said the state will not restrict future borrowing to just fixed rate as a rule, but will continue to evaluate any possible savings that variable-rate debt may offer the state.
"I think we have to look at the market and our costs at any point in time and determine what's the right thing for the state and the debt portfolio," she said.
Other states in the Northeast still have ARS within their debt portfolios. New York still has $1.9 billion of state-backed auction-rate debt outstanding out of a total $4 billion of ARS the state sold through conduit issuers. In addition, Massachusetts has roughly $400 million of ARS outstanding after refinancing about $162 million in early September.
Like New Jersey, Puerto Rico earlier this year was able to refinance, convert - and in some cases, buy back - all of its ARS, which totaled $643.5 million.
"Let's just say [New Jersey] should thank their lucky stars for having gotten out in time and that they don't have to deal with it," said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC. "They were able to get out but not all parties were able to get out so easily so that the offset [might] erase those three years of earlier savings."
Matt Anderson, spokesman for New York's Division of the Budget, said that officials are still reviewing the $1.9 billion of outstanding ARS to determine how best to proceed. He added that the state is currently not comparing its total ARS exposure to earlier fixed rates, as New Jersey has just done.
"Since Sept. 15, the state has not sold any issuances at this point and we are evaluating our entire debt sales for the remainder of the year, both new issuances as well as refunding," Anderson said.