Issuers caught up in the current auction-rate security mess, trying to preserve the bond insurance they have paid for on outstanding auction-rate bonds while still refunding out of auction-rate mode, now have an option.
A new way of refunding auction-rate securities conceived by attorneys at Orrick, Herrington & Sutcliffe LLP may spare issuers the delicate decision of wanting to get out of auction-rate securities but not wanting to lose the bond insurance that is attached to those securities. The San Francisco AirportCommission has already signed on to refund about $200 million of 2006 auction-rate securities insured by Financial Guaranty Insurance Co.
"What we are trying to do is preserve the value on the bond insurance on the possibility that the bond insurer will regain market standing by virtue of its triple-A standing and that sometime in the future the bond insurance will have value again," said Bill Doyle, a partner at Orrick and chair of an insured variable-rate/auction bonds task force at the law firm.
As auctions have failed or seen fewer buyers over the past few weeks, rates for the securities have risen dramatically for many issuers. In response, hundreds of auction-rate programs across the country have begun searching for alternatives.
One solution, in which the auction-rate securities are redeemed at the next auction date, has a drawback in that issuers often pay an up-front premium for bond insurance. Refunding the securities means foregoing the expensive insurance for which they have already paid. It also means giving up swap insurance in the event that the auction rates are tied to a swap. The swap is preserved under the new structure.
"If there is a swap involved, you can continue to hold onto the swap insurance," said Peter Miller, a managing director at Public Financial Management Inc. who is working with Doyle and the airport.
In the new structure, the proceeds from the sale of the new bonds are placed into a trust account. While Miller and Doyle said the solution should be beneficial for many issuers, it is likely limited to enterprise revenue bonds or general obligation issues. Other, more complicated deals involving conduit issuers, or underlying lease agreements, may not work, Doyle said.
"The trust structure would be helpful to us to preserve the value of FGIC if they were to get their rating back," said San Francisco Airport Commission finance director Ben Kutnick. "We couldn't figure out a way to preserve the potential future value of the insurer, [and this does that]."
What is being proposed is a variation on a typical refunding, whereby issuers would refund auction-rate securities and then issue variable-rate demand obligations in their place.
Under a typical refunding, an issuer sells new bonds, placing the proceeds into an escrow account. When the old bonds are redeemed, relatively soon after the sale of the new bonds in a current refunding, or sometime later with an advance refunding, they are essentially canceled and removed from the market.
In the new structure, the issuer gives a notice of an interest-rate mode change for the old auction-rate securities. This causes a mandatory tender for purchase, in which investors must give their securities back to the issuer. "This is typically done if you want to remarket them," Doyle said.
The remarketing agent then sells the auction rates to the trust, which uses the proceeds of the newly sold bonds to buy the old bonds, and then holds them in a trust rather than canceling them, as it would do for a typical refunding. The bonds in the trust are owned by the issuer, which has no tax obligations.
Doyle said the transaction works best if variable-rate demand bonds are used to refund the auction rates that then go into the trust. VRDBs are easily redeemed at any time, and the letter of credit that serves as the liquidity function is easily canceled.
"It doesn't make sense to go through all this trouble if you go to fixed-rate issue because you can't redeem that right away. There is a 10-year call protection from the covenant against redeeming the [fixed-rate] bonds earlier than 10 years," Doyle said. "As a practical matter, this only makes sense if the issuer does its [first] refunding with VRDBs and a letter of credit."
After the first half of the transaction is completed, the issuer has two options going forward. If bond insurance remains beleaguered and the bond insurer that wraps the issuer's bonds in the trust is not returned to an acceptably high rating level, the issuer can collapse the trust and cancel the bonds.
Or the issuer can access the bonds in the trust, asking the remarketing agent to remarket the old bonds in a new interest rate mode.
The remarketing agent then sells the bonds held in the trust to investors in the new interest rate mode, as either the auction-rate securities backed by the same bond insurance policy or as variable-rate demand obligations. The proceeds of this sale are then used to pay off the second issue of bonds, to ensure that both issues are not outstanding.
"[This transaction is] a current refunding just like when you would do a traditional refunding," Doyle said. "If and when you bring the bonds out of the trust, that is another current refunding, of the new bonds."
This structure seems to work with the tax laws that regulate how issuers structure refundings, and Miller said that so far everything has checked out.
"We're still in the process of looking at it and so far it seems to be passing all the tests," he said.
Doyle called it a "plain-vanilla" type transaction in terms of the tax code.
"From a federal tax law standpoint, the bonds purchased into the trust are treated as having been refunded," Doyle said. "So Uncle Sam says if an issuer of securities buys those securities or someone does so on their behalf, we won't consider those bonds as still outstanding."
Analysts at Standard & Poor's have knowledge of this new structure, but have not yet completed a review. And though some investors do not like giving up the high yields currently enjoyed on auction-rate securities, the structure will clearly save issuers money.
"The issuer paid an insurance premium and doesn't want to pay it twice," said David Kotok, chief investment officer at Cumberland Advisors Inc. "I have advised billions of dollars worth of municipal issuance in my lifetime on the issuers' side. Obviously you go to the issuer anytime the issuer can save money - they are usually public bodies and that's their purpose, and you can't blame them."
