States, cities face sky-high payouts on municipal bonds

The worldwide credit market freeze may be claiming a new set of victims: states, cities and other government entities that issued variable-rate bonds and are now facing interest-rate shocks akin to those that hammered homeowners with adjustable-rate loans.

The government agencies at risk issued a hybrid municipal bond known as a variable-rate demand note. The payouts on many of these issues have been driven sky-high by the credit crisis.

The situation prompted California Treasurer Bill Lockyer and 19 municipal treasurers to ask Friday for an emergency Federal Reserve program to restore liquidity to the malfunctioning market and force rates back down.

Without government intervention, there will be higher costs for taxpayers, more budget woes for localities and higher obstacles for crucial infrastructure projects, they said in a letter to California’s Democratic Sens. Dianne Feinstein and Barbara Boxer, House Speaker Nancy Pelosi (D-San Francisco) and House Banking Committee Chairman Barney Frank (D-Mass.).

The variable-rate notes were sold mostly to money market funds. The bonds carry maturities of up to 30 years but pay short-term interest rates that can be reset as frequently as once a day.

Until recently, the resets were not a problem for issuers. The dysfunctional credit markets, however, have exposed them to rate increases no one ever anticipated.

The Los Angeles Metropolitan Transportation Authority, for example, says the rate it is paying on $132 million in variable-rate notes has soared to as much as 12%, from as little as 1%. That’s a difference of as much as $1.2 million in interest a month. The MTA says it may also have to pay $50 million to retire interest-rate swaps it purchased to hedge against interest-rate changes on the original notes.

When variable-rate notes were first developed in the 1980s, they looked like a good deal for issuers as short-term interest rates in the municipal market consistently undercut long-term rates by as much as 3 percentage points. On a $5-billion bond issue, that difference would mean savings for taxpayers of $150 million a year.

Between 1999 and 2007, states and municipalities across the country issued $420 billion in variable-rate notes, Lockyer’s office said. California municipalities and the state itself have more than $60 billion of such bonds outstanding.

“Over the years, they saved us a lot of money,” Deputy California Treasurer Paul Rosenstiel said in an interview. “It was a prudent thing to have a certain amount of our debt at a variable rate.”

But the notes are extremely complex. The interest rates are established daily or weekly by investment banks, which must set them high enough to lure buyers. The notes also allow buyers to demand repayment of the principal at almost any time, a provision known as a put.

To protect themselves against the expense of the puts, the municipalities typically are required to back up the notes with a credit line from a bank, usually through a letter of credit. The credit line or letter of credit essentially obligates the bank to repurchase the notes if necessary.

Until recently, some municipalities also enhanced the bonds’ credit ratings -- and therefore lowered their interest costs -- by backing them with bond insurance. And many municipal issuers further protected themselves against adverse moves in short-term rates by buying interest-rate swaps. These are derivatives that essentially convert floating rates to fixed rates.

Beginning in March, the cascading worldwide credit crisis knocked each of these supports out from under the variable-rate note market.

First, credit-rating agencies downgraded many municipal bond insurers, citing doubts that they would be able to cover all possible claims. This led to ratings cuts on bonds backed by those insurers.

Because money market funds typically must invest only in high-rated bonds, the prospect of downgrades prompted many to exercise their puts, selling the bonds back to their municipal issuers. To lure new buyers, the investment banks began jacking up the rates -- but even that didn’t always lure buyers.

As a result, more notes ended up in the hands of the banks providing the credit lines or letters of credit. This created two new problems, a recent report by Lockyer’s office said. First, under the note terms, those so-called bank bonds carry much higher interest rates and shorter terms, sharply raising the borrowing costs for their issuers. Second, many banks, weakened by the credit crisis, decided to bail out of the variable-rate note market by refusing to renew the credit lines or letters of credit.

Issuers faced with those conditions have only one option: to convert the notes to fixed-rate debt at a higher rate than the original notes.

Municipal bond experts say localities that have good credit ratings and notes backed by strong banks are still successfully saving money with variable-rate notes. But others are scrambling to find new bond insurers, to substitute letters of credit or to convert their notes to fixed-rate bonds.

The credit crisis has made that process more difficult and costly. California on Wednesday received bids for only about one-third of the $523 million in Department of Water Resources notes it attempted to convert to fixed-rate bonds. Investor demand was “close to nonexistent” for the rest, Lockyer’s office said.

Some $350 million of the notes will become bank bonds Dec. 1, exposing the state to higher interest rates and shortened maturities.

“We got caught up, like everyone else, in the deteriorating conditions in the capital markets,” Rosenstiel said. “This is a problem affecting even the strongest issuers.”

Lockyer and his fellow treasurers say the Federal Reserve should support the variable-rate note market in the same way it has assisted the market for commercial paper, the analogous short-term debt for private corporations.

In their letter, the treasurers proposed that the Fed directly purchase “bank bonds,” or make direct loans to banks to finance their own purchases of the debt securities. Either step would preserve the tax exemptions for the notes, which is crucial for keeping rates low, and would give municipalities time to find new backup banks or convert the notes to fixed rates at a reasonable cost.

A Fed spokesman declined Friday to comment on the letter. But he noted that during an Oct. 20 appearance before the House Budget Committee, Fed Chairman Ben S. Bernanke acknowledged that “the municipal bond markets are not functioning well.”

Without giving specifics, Bernanke said “this might be an area where the federal government could assist the state and local governments” by helping them to obtain lower-cost credit.

--

michael.hiltzik@latimes.com