Bernanke Frets as Variable Notes Strip Taxpayers in N.Y., Texas
By Darrell Preston and Michael McDonald
April 16 (Bloomberg) -- Houston’s deputy controller, James Moncur, figured last May the fourth-largest U.S. city escaped the unraveling credit markets by refinancing some of its $1.8 billion of auction-rate bonds.
Instead, Houston wound up paying 15 percent interest on the new securities, not the money-market rates city officials had anticipated. The so-called variable-rate demand notes backfired when investors fled the market in October, forcing the bank that had guaranteed the bonds, Brussels-based Dexia SA, to buy them.
“This was like round two of the great financial crisis of 2008,” Moncur, 56, said. “We were under the impression we had taken care of the problem.”
The $479 billion market for the securities, whose rates are typically reset by banks every day or week, is turning into a quagmire for local officials who embraced a financing strategy they didn’t fully understand. Federal Reserve Chairman Ben S. Bernanke said last month that U.S. taxpayers may wind up as the buyers of last resort for the debt, known as VRDNs.
“A large volume” of variable-rate demand notes were forced back to banks and “exposed the vulnerabilities of the VRDN market, raising questions about the desirability of its continuation as a significant vehicle for municipal finance,” Bernanke said in a March 31 letter to Representative James Moran, a Virginia Democrat.
VRDNs, like auction-rate bonds, offer borrowers short-term interest costs on longer-term debt because rates on the notes are reset at regular intervals. Auction-rate securities fell apart in February 2008 when bankers who had provided support for two decades abandoned the market, stranding investors with notes they couldn’t sell and borrowers with annualized interest as high as 20 percent.
Dozens of local governments sold VRDNs to pay off their auction-rate obligations. Lower-rated borrowers in the variable- rate market are required to have a guarantor, called a credit facility provider, who promises to buy bonds investors don’t want. Interest rates are set by banks at a level they expect investors will accept.
The market lost favor among municipalities this year as costs to guarantee the bonds increased and issuers incurred unexpected charges to get out of their privately negotiated transactions.
Sales of tax-exempt debt with variable interest rates plummeted 55 percent to $9.6 billion in the first three months of the year, according to data compiled by Bloomberg. New issues dropped even as the average weekly rate on the securities fell below 1 percent, to as low as 0.48 percent on Feb. 4.
Rising Guarantee Cost
Houston agreed to pay the 15 percent annual rate for 60 days, Moncur said. Harris County, Texas, later bought $118 million of the city’s taxable VRDNs and the rate is currently 6.9 percent, he said. Houston is the Harris County seat.
Banks, reeling from almost $1.3 trillion in credit market losses since the start of 2007, raised the cost for providing guarantees as much as 10-fold, Concord, Massachusetts-based Municipal Market Advisors said in January.
Some borrowers that want to refinance VRDNs are stuck since the bonds are “often paired with interest-rate swaps that would be quite costly to unwind because many of the swaps are now underwater,” Bernanke said.
Municipalities use swaps -- private agreements in which a borrower and another party agree to exchange interest rates -- to create fixed-rate obligations by joining them with variable- rate debt. If the arrangements go awry, issuers have to pay fees to terminate the contracts.
The New York State Dormitory Authority wound up paying bankers $26.8 million to get out of $390 million of VRDNs last month, after Dexia increased the fees for its letter of credit to 0.5 percent from 0.27 percent and interest rates on the bonds rose as high as 8.48 percent, according to public disclosures.
Besides the cancellation fee, the dormitory authority paid $2.76 million to underwriters led by Goldman Sachs Group Inc. to sell about $500 million of new bonds.
As with all variable-rate notes and swaps, terms of the sale were set in negotiations with underwriters, not through competitive bidding. When fees from the new debt are added to interest, the total financing cost was 6.11 percent, according to Marc Violette, a Dormitory Authority spokesman.
The yield on the Bond Buyer 20 index of interest costs on 20-year general obligation bonds averaged 4.96 percent for the past year. The new dormitory bonds, like the old, were backed by state appropriations and financed the construction of mental health facilities.
Borrowers in the $2.69 trillion market for state and local government debt increased swap agreements while abandoning sales of bonds through competitive bidding.
Competitive sales reduce interest costs on municipal debt from 0.17 percentage point to 0.48 percentage point, according to a study by Mark D. Robbins, an associate professor at the University of Connecticut in West Hartford, and Bill Simonsen, a professor at the institution. The survey, titled “Persistent Underwriter Use and the Cost of Borrowing,” was published in the winter 2008 issue of the Municipal Finance Journal.
VRDN fees may increase because banks don’t want to risk being forced to buy bonds that investors shun, said Michael Marz, vice chairman of First Southwest Co. in Dallas, the third- largest financial adviser to state and local governments.
Most variable-rate debt requires a bank guarantee to be eligible for sale to money market funds, and banks are only willing to back the highest-rated credits, said George Friedlander, a municipal market analyst at Citigroup Inc., in an April 3 report.
Local governments with credit ratings above A- can obtain letters of credit, while those with lower grades are struggling, said Michael Decker, co-chief executive officer of Alexandria, Virginia-based Regional Bond Dealers Association, which represents about 20 securities dealers and underwriters, most based outside New York.
Mendocino County, California, was rejected for a $26 million loan in a pool of borrowers seeking short-term funding for operating expenses because its rating was too low for the bank backing the debt, said Shari Schapmire, the county treasurer. Mendocino, which has an A- rating from Standard & Poor’s, may have to pay $750,000 more to get the money on its own, which may force officials to trim some of the government’s 1,400 workers, she said.
Variable-rate borrowers “are experiencing substantial increases” in costs, said Bernanke in his letter. The market for municipal variable-rate debt “appears to be under more stress” because investors have been putting their bonds back to the guarantor bank, he said.
State and local governments have asked the U.S. government to provide guarantees for VRDNs as costs of bank assurances rise. U.S. Representative Barney Frank’s Financial Services Committee is writing legislation to help create a new backstop.
Houston’s decision to convert to variable-rate debt has drawn criticism from Councilman Peter Brown, who said officials shouldn’t have agreed to floating-rate debt with a 15 percent penalty rate, given the turmoil in financial markets.
“The city ended up holding the bag,” said Brown, who is running for mayor. “We should have been smarter so we were not put into this position.”