San Diego County Rethinks VRDOs

SAN FRANCISCO - San Diego County is facing surging rates on its variable-rate pension debt, forcing California's second-most populous county to consider tapping reserves to pay down the debt and to cancel plans to issue more variable-rate paper.

The variable-rate market instability of past months has convinced officials in San Diego to restructure a $375 million lease-revenue bond offering, which was previously planned to include $75 million of variable-rate demand obligations, as an all fixed-rate deal. The county has delayed the sale until market conditions stabilize.

"We don't know if rates will come back down to pre-September levels, but certainly, we don't want to price in an irrational market," said Ebony Shelton, finance director for the county's finance and general government group.

San Diego County is paying 8.15% to 8.5% on $70 million of taxable variable-rate demand pension bonds issued with a standby bond purchase agreement from Landesbank Baden-Wurttemberg in July to repair failed auction-rate securities. Another $30 million has been put back to the bank at a rate of 6.5% with an accelerated three-year repayment schedule.

Rates have remained high even after the German government announced a bailout of the nation's banking sector that may help LBBW, Germany's largest state bank. Standard & Poor's revised the outlook on the bank's A-plus counterparty rating to negative on Sept. 19.

The bank's woes and recent VRDO market dislocations have pushed the rates on the county's variable-rate pension debt so high that the county is now making plans to either pay the debt off early or to restructure, Shelton said.

San Diego County issued the bonds on the assumption that they would carry a lower interest rate than the county earns on its pension fund. It assumes an 8.25% rate of return on the pension plan, and has issued about $1 billion of pension debt to fund the plan. 90% of the bonds are fixed rate and unaffected by the current market turmoil.

San Diego County has a AAA issuer rating from Standard & Poor's, a AA-plus implied general obligation bond rating from Fitch Ratings and a Aa2 issuer credit rating from Moody's Investors Service.

The poor performance of the variable-rate market has convinced the county to restructure a $375 million new-money deal that will finance a new administrative campus, called the County Operations Center. The county now plans to issue the entire deal as fixed-rate debt.

"We don't need to take the risk, so why do it?" Shelton said. "The intent of having the variable-rate component was to give us pre-payment flexibility."

She said the county plans to reduce future borrowing rather than paying off the operations center debt early. In the meantime, Shelton plans to hold off on the financing until the market settles down.

"We're not in a hurry to get in the market because of the change in the credit spreads for municipals," Shelton said. "The good news there is that we were actually contributing cash to the project and we're able to live off the cash until the market gets a little bit more rational."

The Bond Buyer 40 index of long-term municipal bond yields surged to a high of 8.01% yield to par call on Oct. 15 from 5.35% just before Lehman Brothers' bankruptcy last month.

The spread between The Bond Buyer 20-bond index and 10-year Treasury notes expanded to a record 206 basis points last week, as muni yields surged to 152% of comparable Treasury yields.

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