Another Debt Market For Governments Loses Buyers, and Rates RiseBy LIZ RAPPAPORT
February 28, 2008; Page C1
SourceBanks and municipalities can't catch a break these days.
A new round of higher debt costs confronts some states and cities as another usually humdrum part of the credit markets runs into trouble. This time, the culprits are variable-rate demand notes. And banks that guarantee they will act as buyers of last resort face something they never expected -- having to purchase many of them at once.
Variable-rate demand notes let issuers borrow for long periods -- but at short-term interest rates. Like auction-rate securities, interest payments adjust on a weekly or even daily basis. The difference is that for variable-rate demand notes, securities firms sell the debt at whatever interest rate meets the market's demand.
The problem: Just like many issuers of auction-rate securities whose interest costs soared after auctions for some of their debt failed, an increasing number of municipalities are being hit with sharply higher interest on their variable-rate demand notes because dealers of the debt are having trouble selling it.
Last week, rates on $300 million of California's variable-rate demand notes rose to 8.25% from 2% the previous week. "This is an amazing confluence of problems that no one expected to happen," California Deputy Treasurer Paul Rosenstiel said.
"The entire floating-rate [municipal bond] market is in disarray," said Michael J. Marz, vice chairman at First Southwest Co., a Dallas financial adviser to governments and municipalities. There are about $500 billion of variable-rate demand notes in the market compared with an estimated $330 billion of auction-rate securities.
In the auction-rate market, when auctions fail to generate enough bidders, investors are stuck holding investments they can't cash out of. With variable-rate demand notes, securities firms unable to sell the debt -- as has been happening for the past couple of months -- have the right to essentially turn the bonds over to a bank that has guaranteed to buy them.
With limited room on their balance sheets to hold the ballooning inventory of variable-rate demand notes, firms such as Bear Stearns Cos., Lehman Brothers Holdings Inc. and Morgan Stanley have bounced bonds back to "backstop" banks or notified them that they may do so in coming days and weeks if their sales efforts continue to founder.
The largest participants in the backstop business include Bank of America Corp., J.P. Morgan Chase & Co., Citigroup Inc. and State Street Corp. Also, Depfa Bank of Dublin and several other European banks have a sizable presence.
"We as a community can't be warehousing all the risk" of holding inventory of these assets on the balance sheet," said a treasurer at one broker dealer that expects to sell back some bonds to liquidity backstop banks. As the end of the first quarter nears, many firms that once supported the market by buying and holding the notes are being extra cautious and trimming their fixed-income inventories, a municipal-bond banker said.
When the backstop banks buy the bonds, the debt turns into so-called bank bonds. The interest payment rises to the prime rate -- or an amount even higher than the prime rate, now 6%.
One banker at a large backstop provider said his bank has taken back about $500 million in variable-rate demand notes out of a total portfolio of more than $20 billion in backstops. That bank hadn't inherited any municipal bonds in 30 years, but more are likely this week and next, the banker said. Holding the bonds isn't necessarily financially bad for the banks, because the securities collect 6% on high-quality municipal debt But for some banks with balance-sheet pressures, taking back lots of bonds at once could be burdensome.
For bond issuers, though, shifting the unsold debt to backstop banks requires the municipalities to repay the debt faster. Typically, the maturity of such bonds becomes five years instead of the intended 20 years or 30 years.
"It could happen," said Mr. Rosenstiel, the deputy treasurer in California, though state officials are planning to refinance the $300 million in variable-rate demand notes as soon as possible into fixed-rate bonds or another type of debt.
Money-market funds, which have strict rules on the kinds of securities they can buy, usually are major participants in the variable-rate demand notes market. Many such funds have 70% or more of their assets invested in those securities.
But their interest is waning because of wariness about any securities backed by bond insurance, particularly those insured by Financial Guaranty Insurance Co. and XL Capital Assurance Inc., whose ratings have been cut in recent weeks.
The SIFMA Swap Index, a benchmark for variable-rate demand notes that reset weekly, reflects the market turmoil. That index rose to 2.37% from 1.24% in the week ended Feb. 20., and to 3.16% yesterday. Typically, the index yields much lower than the three-month London interbank offered rate. Now, it's about equal. Libor was 3.1% yesterday.
--Shefali Anand contributed to this article.
Write to Liz Rappaport at
liz.rappaport@wsj.com