Misery for municipals

The US municipal market endured a tumultuous 2008. The downgrades of many of the leading monoline insurance companies in late 2007 and early 2008 triggered an investor exodus from variable-rate demand notes (VRDNs), along with the implosion of the auction rate securities (ARSs) market last February. The situation was worsened by the exit of Bear Stearns last March, the collapse of Lehman Brothers in September and the withdrawal of several dealers from the municipal market, severely restricting the financing avenues available to local authorities.

This year is shaping up to be similarly miserable. Municipals are grappling with significantly higher costs for the lines of credit necessary for local authorities to access the VRDN market - that is, if banks permit credit arrangements to be extended at all. For those that have seen credit lines pulled, many are being hit with hefty termination fees on now unnecessary interest rate swaps positions, originally designed to synthetically fix floating-rate payments on VRDN and ARS issuance.

For some local authorities, the millions of dollars in termination fees could be the straw that breaks the camel's back, driving them away from the derivatives market. To add insult to injury, many now have to issue fixed-rate bonds at painfully high levels to refund VRDN and ARS investors and retire the debt.

VRDNs are short-term floating-rate notes that pay interest based on a specified money market rate, such as three-month Libor or the Securities Industry and Financial Markets Association (Sifma) municipal swap index. These instruments contain a put option that enables investors to sell the notes back to the remarketing agent (typically an investment bank) at short notice, should they decide to liquidate their investment. This facility is backed by a letter of credit or a standby bond purchase agreement between the remarketing agent and the VRDN issuer.

These notes were often wrapped by monoline insurance companies - a result of municipal issuers' eagerness to win AAA ratings on their VRDNs and so attract the bevvy of money-market funds restricted by US Securities and Exchange Commission rules to investing in securities rated AA and above. However, the downgrading of the major monoline companies in late 2007 and 2008 triggered a chain reaction that eventually led to the blow-up of the ARS market.

With the rating agencies embarking on a series of monoline downgrades, money-market funds elected to put VRDNs back to investment banks en masse in January and February last year. With already under-pressure balance sheets becoming overloaded with VRDNs, banks pulled back from the related ARS market. These instruments are long-term variable-rate bonds that have their interest rates reset through a series of Dutch auctions held every seven, 28 or 35 days. ARSs essentially allowed issuers to sell long-term debt, but secure lower interest rates on short time horizons. For their part, investors were able to invest in these notes, while retaining the liquidity typically associated with money-market instruments.

Key to the liquidity was the role played by investment banks as auction agents. Should no buyer emerge at an auction, the banks would act as buyers of last resort, ensuring the auction did not fail. However, as investors became increasingly nervous, more and more auctions were unable to attract sufficient buyers. With banks already bloated with VRDN issuance, many pulled out of their backstop role simultaneously last February - causing the market to vanish overnight (Risk April 2008, pages 50-52).

For many ARS issuers, the remainder of 2008 was spent restructuring their financing, with many looking to shift into the VRDN market. However, those that have been able to move into this market, or have renewed existing facilities, are finding they have to pay significantly higher costs for letters of credit.

A municipal treasurer from a state housing authority, who spoke to Risk on condition of anonymity, illustrates the gulf in the cost of financing between 2007 and 2009. "We have a fairly large variable-rate debt programme and just completed a one-year renewal of a $250 million line of credit. In January 2007, we were charged 9 basis points for the facility, which we replaced in January 2008 for 18bp. Last month, we were told by the remarketing agent they wanted more than 100bp to renew the line of credit for 2009," he says.

Others, particularly those with lower credit ratings, are having credit facilities turned down, giving them little alternative but to issue fixed-rate bonds - at hugely inflated costs. Dealers report yields on 30-year fixed-rate municipal bonds start in the region of 475bp, as municipal bond investors demand higher returns in an uncertain environment. That compares with a yield of 324bp on the 4.5% 2038 Treasury bond on January 27.

On top of that, many floating-rate debt issuers had entered into swaps to fix their interest rate payments. As a result, those refinancing ARS and VRDN issuance with fixed-rate debt are finding themselves saddled with unwanted floating to fixed swaps - forcing municipals to pay bulky termination fees.

In its Annual Performance Report: Interest Rate Exchange and Similar Agreements for the 2007-08 Fiscal Year, the New York State Division of Budget revealed the state refinanced certain ARSs with fixed-rate bonds last year. In doing so, it had to terminate $973 million of swaps at a mark-to-market cost of $44.6 million as of September 30.

The picture was similar in Miami-Dade County in Florida, which in July 2008 issued $68 million in fixed-rate water and sewer bonds to be used to pay a portion of the termination costs for an interest rate swap agreement.

"I'd say 90% of all municipal swaps are a synthetic conversion of floating-rate to fixed-rate debt, but the banking crisis has caused extreme difficulty for municipals to access lines of credit to backstop their VRDNs," says Peter Shapiro, managing director of New Jersey-based investment management advisory firm Swap Financial Group. "Miami-Dade could not find a replacement liquidity facility for its floating-rate bonds when its bond insurer encountered trouble, so it had no choice but to convert the bonds from floating to fixed, at which point the swap becomes superfluous. In fact, in many cases, municipals are not legally allowed to have that swap outstanding since they are not hedging anything and have to terminate - it's a naked swap."

Interest rates have plunged in recent months, as the Federal Reserve has cut its main federal funds rate, pumped liquidity into the money markets, and propped up the major banks with capital injections. Three-month dollar Libor was hovering at near record lows of 1.15% on January 22, compared with 4.68% on January 2, 2008 and 5.36% on January 2, 2007. As recently as October 10 last year, three-month Libor was fixed at 4.82%. The Sifma municipal index was also close to record lows, at 0.46% on January 22. At the start of 2008, the index was fixed at 3.06% and reached as high as 7.96% on September 24 last year.

For those local authorities looking to unwind floating to fixed rate swaps, the drop in rates means they would be facing costly termination charges, as the swaps would be heavily underwater. Nonetheless, there were some municipals that were ahead of the curve and managed to unwind swaps before interest rates went into freefall in the last quarter of 2008.

For instance, the Metropolitan Water District of Southern California entered into a swap with American International Group (AIG) in the mid-1990s, but successfully terminated the transaction just months before the ailing insurance giant ran into trouble last September, forcing it to accept a rescue package from the Federal Reserve.

"The swap in question was worth around $85 million, and we managed to terminate it around nine months ago for less than $8 million, which we felt was a relatively small payment," says Brian Thomas, chief financial officer at the Metropolitan Water District. "We terminated it since we were concerned about AIG and because it was a longer-dated swap. We had entered into it when AIG was pretty much the only player in the market and we found the provisions of the contract to be pretty onerous. It was a synthetic fixed-rate cost-of-funds swap and we are now simply in a variable-rate mode where interest today is between 0.1% and 0.5%."

The higher cost and lack of availability of credit lines for VRDN issuers is partly a result of market conditions, but is also due to the fact a number of banks have withdrawn from the market. Some new firms are stepping into the breach, providing lines of credit where available - albeit at a premium. Local authorities say large regional investment banks such as Royal Bank of Canada, Tennessee-based Morgan Keegan and Florida-based Raymond James are taking up some of the slack. On Wall Street, however, the liquidity provision being extended by the largest broker-dealers is described as sketchy at best.

Participants point to their experience in the wake of the collapse of Lehman Brothers on September 15 as best illustrating how Wall Street firms have changed in their treatment of municipal customers. Those local authorities that had derivatives trades in place with Lehman Brothers found various dealers were willing to step in to help unwind, replace, restructure or novate trades. However, some banks were notable by their absence.

"The Commonwealth of Massachusetts had three swaps with Lehman Brothers, but we found replacement counterparties to step in. We didn't have to change any of the structure of the swaps and it ended up costing us nothing, so the system worked - but not as well as it should have since a lot of the swap counterparties did not participate in the replacement process," says Colin MacNaught, assistant treasurer for debt management at the Massachusetts Office of the State Treasurer in Boston.

With some municipals now frozen out of the VRDN market due to the lack of credit facilities, issuers find themselves having to pay significantly higher costs for fixed-rate debt, at a time when floating-rate benchmarks are plummeting. The benefits for those still able to issue VRDNs are clear.

"In a normal market, using a swap to create synthetic fixed-rate debt would save perhaps 50bp compared with issuing fixed-rate bonds. Today, we see savings in the region of 300bp to 500bp. Many fixed medium-rated bonds are selling at 7% or more, but recently we did a swap for a housing finance agency where the synthetic fixed rate they received was under 250bp," says Shapiro of Swap Financial Group.

As such, those municipals that have issued fixed-rate debt and are still willing to execute derivatives are pondering using fixed to floating swaps, say some participants. These instruments would allow the issuer to pay floating rate plus a spread, yet would not require the same liquidity provision as a VRDN: there is no obligation for the dealer to take the fixed-rate bond on to its balance sheet at short notice, unlike the VRDN market.

This solution is not without its downsides. Libor may currently be at record lows, but was above 4% at recently as last October. An issuer locked into a fixed- to floating-rate swap may therefore find it is making hefty interest rate payments once the market recovers.

Nonetheless, dealers expect to see more transactions of this type over the coming year - and as such, believe predictions of a slowdown in the municipal derivatives market are premature. "I would argue we're going to see a lot more synthetic floating debt in 2009 than we have seen over the past five years. The Sifma index, which has set historically at 65-67% of three-month Libor, is now around 50% of three-month Libor, which is currently around 1%. If you have a fixed-rate bond issued at 6% and swap it back to Sifma plus 250bp, that's an all-in floating rate of 3% right now. Derivatives will still be used to access fixed rate or floating rate for debt obligations," says Carlos Rodriguez, head of US municipal derivatives at Deutsche Bank in New York.

Although the savings are undeniable, the single biggest obstacle the market may face concerns the perceived counterparty risk of dealers, with fourth-quarter results showing no sign of improvement among the big Wall Street banks. Confidence in swaps generally has also been bruised by the collateral calls faced by some issuers as the mark-to-market value of their swaps moved into negative territory.

Despite the seemingly unavoidable hikes in funding costs local authorities may have to endure this year, most participants agree there will probably not be any regulatory change in the sector, as the market - beyond the defunct ARS sector - has continued to trade in a normal, if distressed, manner. Consensus from market participants is that credit default swaps and structured credit products will bear the brunt of supervisory scrutiny, alongside reviews of rating agency methodologies and the continued use of mark-to-market accounting.

An anxious 2009 lies ahead for municipal entities, but it will almost certainly be a tough year with more pain to come. "We've been successful in the past year extending our existing VRDNs, but renewals are a concern over the course of this year. In terms of new variable-rate debt, in which borrowing costs would be much lower for municipal issuers, the market will see very little of it sold in this environment. Instead, issuers will be forced to sell into a more expensive fixed-rate market because they don't have the opportunity to sell efficiently priced short-term bonds where there is arguably significant demand," says Massachusetts' MacNaught.