Richard Ellis

I remember last summer when the first concerns about the sub-prime mortgage market were raised. The public was reassured that the damage was “contained” and wouldn’t ripple through to other segments of the capital markets. How wrong that has proven to be.

Now, nearly a year later, issuers of taxable and tax-exempt debt are scrambling to refinance variable rate bonds issued as Auction Rate Securities (ARS). For 20 years issuers have issued long-term debt at short-term rates using ARS. In other words, the bonds might mature in 20 years, but the interest rate paid was based on a 7, 28 or 35 day auction rate. On the remarketing date, the bonds would go through an auction process to establish a new interest rate.

One advantage to this type of variable rate debt is the lack of the need for a liquidity facility. The bonds were issued with bond insurance which guaranteed the payment of principal and interest in the event of default. This saved 15 or 20 basis points (1 basis point = 1/100 of a percent) in fees, which means a lot when the remarketing rates are in the 2 to 3 percent range.

Since February 12, the vast majority of auctions have failed, meaning there was not enough demand from buyers to match the supply from sellers. The result is the seller is stuck with a bond that they don’t want.

So how did we get to this point? The bond insurers expanded their business to insure structured investments that included sub-prime mortgages. As these investments have started to fail, the capital of the bond insurers is consumed covering these losses. This led to the bond rating agencies downgrading the bond insurers because they no longer had sufficient capital to cover their liabilities.

With the bond insurer having a lower rating, investors can no longer legally purchase, or may refuse to purchase, the ARS. The investment banks that remarket the ARS, which have traditionally made a market for ARS securities, have their own capital problems as they are forced to write down billions of dollars of losses. With no one buying, the securities have no liquidity and the seller is left holding the unwanted bond.

This is an over simplification, but reflects the realities of the market. The ARS market, which has thrived for over 20 years, appears to be headed to complete collapse. Ironically, many of the credits backing the ARS securities are very strong, but the buyers are gone. As a result, the municipal bond market is flooded with refinancing or conversions of ARS into fixed rate bonds or other types of variable rate bonds that are more expensive. 

Treasurer Bill Lockyer of California is pushing the bond rating agencies to eliminate separate rating scales for tax-exempt and corporate bonds. In March, he circulated a letter to all state treasurers asking them to join him in his efforts. His work has not gone unnoticed by the rating agencies (at least Moody’s and Fitch). Even Congress has held hearings regarding this topic.

His argument is based on default rates. A single A rated tax-exempt issuer has a similar default history as that of a triple A rated corporate issuer. Single A municipal issuers end up purchasing bond insurance so they can receive the lower interest rate associated with a triple A rating (that was before the recent implosion of the monoline insurers). A common scale would eliminate this cost for lower rated municipal issuers because they would be triple A.

Having a global scale seems to make some sense then. However, the rating agencies consider factors, other than default rate, when assigning ratings. Four general areas are considered in a rating agency analysis: 1) Economic factors; 2) Debt structure; 3) Financial factors; and 4) Management strategy.

So what does this mean if Treasurer Lockyer is successful in his quest? We would see all issuers of bonds, both municipal and corporate, on the same rating scale. But I wonder if the world is unchanged in practical terms.

From Shakespeare’s Romeo and Juliet we read, “What’s in a name? that which we call a rose by any other name would smell so sweet.” The same applies here. Municipal credits will still need to be differentiated from one another. Both California and Virginia could be triple A, but they are still not the same credit. It doesn’t matter what you call them there is a difference in the credits. As a bondholder, I would much prefer a Virginia bond over a California bond. The rating agencies will still have to differentiate by expanding the scale to quadruple A or adding a 1-5 designation to the triple A scale.

This leads to market pricing. Even if the credits have the same rating, I have to believe that the market will continue to price credits differently. Large institutional buyers do their own credit analysis. They will make their own differentiation. The best credits will continue to issue debt at an interest rate that is lower than the weaker credits. Will the best credits get an even lower interest rate? I doubt it. Municipal bond credits will continue to trade at the same levels as they have historically. Again, the need for bond insurance will continue.

This will play out over the next several months. The nice thing about Utah is we don’t have a dog in this fight because we already have a gilt-edged AAA bond rating. It saves us millions of dollars per year.