In the News: Recent Developments

4 February 2008

MUNI WATCH: More Insurer Fallout As Muni Auctions Fail


NEW YORK (Dow Jones) — A tortuously slow and painful credit ratings shakeout in the beleaguered bond insurance industry has helped cause the failure of U.S. municipal bond auctions – the first known instance of this since 1991.

Over the last two weeks, at least six auctions of tax-exempt auction-rate securities – one of them by Georgetown University in Washington, D.C., and all insured against default – failed to draw sufficient investor interest in these sales designed to open up cheaper financing for local governments.

Tax-exempt auction-rate bonds, which represent about $250 billion in outstanding debt, are a form of variable-rate debt that effectively converts long-term bonds into short-term securities. Bondholders gain liquidity by being able to sell them at weekly or monthly auctions, and issuers benefit from rates that are substantially lower than those of traditional fixed-rate long-term municipal bonds. But if not enough buyers show up, and an auction fails to clear, the issuer has to pay a stiff penalty rate that can run into the double digits.

Meanwhile, a slowing national economy and a badly bruised housing market already have thrown state and local government tax revenues into a slump. If their ability to raise the low-cost capital that the auction-rate market provides is compromised, they may face some tough choices.

The auction failures shed new light on how vulnerable some municipal bond issuers have become in the current credit market shakeout that has rocked what had been considered a safe corner of the capital markets.

Losses at leading bond insurers, which have insured roughly half of the $2.6 trillion municipal bond market, however, have put their stellar triple-A ratings at risk, which in turn threatens the ratings of the bonds they insure. All of the fails were insured issues, and most carried underlying ratings in the single-A range.

While at least some of the issues that failed in the past two weeks have subsequently cleared at later sales, the development marked the first known failures of tax-exempt auction-rate bonds since September of 1991, when securities backed by Tucson Electric Power Co. and issued by the Pima County Industrial Development Authority, Ariz., broke a string of 16 straight monthly failures. The penalty rate then reached 12.6%.

The failures also raise questions about the willingness and ability of capital-constrained Wall Street broker-dealers to support the bond auctions, which they did frequently in the past to stop them from failing, even though they weren’t required to do so.

“The market for this paper is in disarray,” said Joseph S. Fichera, chief executive officer of Saber Partners, a New York City-based financial advisor to public entities and corporations. Fichera in 1991 had been a managing director in corporate finance at Bear Stearns & Co. (BSC) and helped Tucson Electric Power convert its tax-exempt floating-rate debt to fixed rates after a successful auction was finally held.

“There is just a flight away from any of the insured deals” now and a “tremendous dislocation” as cash managers and individual investors discover that their ability to sell in auctions has been crimped, he said.

Another sector of the tax-exempt floating-rate market also has come under pressure recently as a combination of troubled insurers and a leveraged arbitrage strategy employed by broker-dealer proprietary accounts and by hedge funds backfired. This has resulted in significant selling of long-term bonds enhanced by bond insurance because the bonds are open to the same downgrades being faced by insurers.

Bond insurer Ambac Financial Group Inc. (ABK) already was dropped by Fimilac SA’s Fitch Ratings to double-A from triple-A, and has been placed on watch for a downgrade by Moody’s Investors Service, a Moody’s Corp. (MCO) unit.

It used to be that credit wasn’t an issue in the once-vanilla municipal bond market, not only because of the strength of state and local governments but also because of the prevalence of bond insurance. Now, “it’s a matter of urgency before the credit issue also plays out in the auction market,” said Lance Pan, director of credit research at Newton, Mass.-based Capital Advisors Group.

Among the issuers discovering on Jan. 22 that it isn’t so easy any more to peddle bonds at auction were Georgetown University and Clark County, Nev., which acted as a conduit issuer for Nevada Power Co., a unit of Las Vegas-based Sierra Pacific Resources (SRP).

Georgetown is “reviewing the current volatility of bond auctions” and mulling the “appropriate course of action” to best meet its long-term financial position, said the university’s Chief Financial Officer, Christopher L. Augostini, in an emailed statement.

Sierra Pacific CFO Bill Rogers said he has considered alternatives to auction-rate paper, such as issuing longer-term tax-exempt bonds at a fixed rate, but “We’re hopeful that this particular experience is a blip,” he said.

Sierra Pacific utilizes 11 auction-rate programs totaling $560 million for Nevada Power and for Sierra Pacific Power, another unit, Rogers said. The auction that didn’t clear was for $115 million, which forced the utility to pay bondholders a penalty rate of 6.759%. The auction cleared on Jan. 29, and the rate was reset at 5.25%.

Lehman Brothers (LEH), which acted as dealer for the Nevada Power auctions, also was named by sources as the dealer for the Georgetown issue. Both issues were insured, Nevada Power by Ambac and Georgetown by MBIA Inc. (MBI), the muni market’s No. 2 and No. 1 bond insurers, respectively.

Lehman spokeswoman Kerri Cohen said she could only verify that that the Georgetown issue subsequently cleared.

Sources also said Minneapolis, Minn.-based Piper Jaffray Cos. (PJC) acted as dealer in four failed auctions last week, three insured health care deals on Monday and one insured education bond auction Thursday. Spokesman Rob Litt didn’t respond to emailed questions.
By Stan Rosenberg, Dow Jones Newswires, 201-938-2143;

(Stan Rosenberg, a veteran observer of the municipal bond industry, writes about issues and trends in the muni market for Dow Jones Newswires.)

Copyright (c) 2005 Dow Jones & Company, Inc.

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