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Bond Issuers, Assess Your Debt Portfolio in Tumultuous Times

Problems in the municipal bond market began to manifest themselves in the fourth quarter of 2007 as some of the largest bond insurers were placed on negative watch with a potential for downgrade by rating agencies, due primarily to losses suffered by insurers in their guarantees of subprime mortgage backed securities, also known as collateralized debt obligations.

Three primary rating agencies that rate municipal bonds, Standard & Poor's, Moody's Investors Service and Fitch Ratings, have become concerned that some bond insurers' capital reserves may be insufficient in light of potential significant increases in losses from the insurers' guarantees of failing mortgage backed securities. Certain capital guidelines must be met for bond insurers to maintain their top level triple A ratings. After the initial negative watches, actual downgrades of certain bond insurers followed, leading to failed auctions of auction rate securities ("ARS"), major increases in interest rates borne by variable rate demand bonds ("VRDBs") and concerns about interest rate swaps entered into in connection with the issuance of ARS and VRDBs.

Auction Rate Securities
ARS, which are often insured, have been significantly impacted in recent weeks and it is not certain whether the auction rate structure will survive for municipal issuers. Between 1986 and 2004, the Bond Buyer reports that less than 20 auctions failed, as compared to a total of more than 30 failed auctions in just the last two weeks of January 2008, and the trend continues. Issuers of ARS have had to make some difficult decisions even if their auctions have not failed. The rates being paid by issuers to investors in successful auctions is currently high because the reduced demand has caused issuers to pay higher yields in order to sell the securities at auction. Those that retain ARS after a failed auction are receiving a default rate that is set either by contract or state statutes, and are often as high as 12% to 15%. The U.S. Treasury Department has clarified rules which may eliminate certain tax concerns with restructuring ARS, converting ARS to another interest rate mode, replacing a bond insurer or "wrapping" a bond insurance policy with other credit enhancement.

Variable Rate Demand Bonds
VRDBs have also been impacted by the bond insurer downgrades and the failures in the auction market. Many VRDBs are held by money market funds, which are required under federal law to hold securities having ratings in one of the two highest rating categories. Fund managers are moving away from VRDBs to other investments. Although many VRDBs are backed by letters of credit and not by bond insurance, the market has been impacted by ARS being converted to VRDBs and banks are reaching their capacity to issue new letters of credit, particularly in this tight credit market. The prices issuers pay for credit facilities are climbing and some banks are telling issuers that they either cannot issue a liquidity facility at this time or they will have to wait until capacity increases, as other bonds mature and capital coverage increases.

Interest Rate Swaps
Interest Rate Swaps have been a way for issuers to hedge interest rate risk while diversifying their debt portfolios. Many interest rate swaps are entered into at the time that issuers issue ARS or VRDBs and then they "swap" them with a counterparty for a synthetic fixed rate. Interest Rate Swaps can vary widely and the terms of each transaction are dictated by the issuer's agreements with the counterparty. If an issuer has issued ARS and swapped them for fixed rate payments, the issuer could explore options, including the possibility of converting to a variable rate and staying in the swap or refinancing the auction rate bonds and terminating the swap by issuing fixed rate bonds. In either case, there are issues to consider, such as the cost of obtaining a liquidity facility for the variable rate bonds, as described above, and if issuing fixed rate bonds, the potential for paying a termination fee for canceling the swap. Issuers may however be permitted to finance any termination fees by including them in the refinancing issuance of fixed rate bonds.

Impact on Fixed Rates
The near crisis conditions in the variable rate markets and the resulting liquidation of tax exempt hedge funds has also had a dramatic impact on interest rates for fixed rate municipal bonds. For the two weeks ended February 29, 2008, The Bond Buyer 20 Bond Index increased over 50 basis points. Scheduling and structuring for new issues, whether credit enhanced or not, is a major challenge for issuers and their advisors in these volatile market conditions.

ACTION PLAN FOR ISSUERS

Although the municipal bond market is turbulent, now is a great time for issuers to assess their portfolios and communicate with their financial advisor, underwriters and bond counsel to formulate an action plan for addressing instability in the market and potential increases in interest costs. It is difficult to budget for fluctuating interest costs in a chaotic market and as budgets tighten, it is important for issuers to understand how their debt obligations impact their budgets. The following steps should be taken to ensure that issuers understand their outstanding debt obligations and how they may be able to take action to stabilize their portfolio and achieve the lowest cost of capital for their new issues:

Take Inventory of Your Debt Portfolio. Finance officers should start by preparing a summary of all outstanding debt obligations.
Categorize Bonds. Determine whether bonds bear interest at variable rates or auction rates and note the bond insurer and liquidity facility or letter of credit providers, including termination rights of the providers. Additionally, list any interest rate swap transactions and what bonds were issued, if any, in connection with those swap transactions.
Create a Plan With Your Financial Advisor, Underwriters and Bond Counsel. If your portfolio consists of VRDBs, ARS or interest rate swaps, confirm their current status by contacting your financial advisor and underwriters. They will help you determine if you need to take action or explore refunding opportunities to stabilize rates and assuage concerns about further instability in the municipal bond market.

It is important to think ahead but also to do so with proper counseling, as certain suggested ways to proceed could raise securities and tax law concerns and should be discussed with counsel. In this time of uncertainty, being prepared and well informed is the best approach.

This Bulletin was primarily written by Benjamin S. Parvey II, an Associate in Saul Ewing's Public Finance Department. If you have questions or wish to discuss the contents of this Bulletin, please contact George Magnatta, Chair of the Public Finance Department, at 215.972.7126 or gmagnatta@saul.com.

The provision and receipt of the information in this publication (a) should not be considered legal advice, (b) does not create a lawyer-client relationship, and (c) should not be acted on without seeking professional counsel who have been informed of the specific facts. Under the rules of certain jurisdictions, this communication may constitute "Attorney Advertising."

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