Tuesday, August 05, 2008

sic semper debitum part ??

OK... big big wonk quotient follows... but for public finance nuts out there...

I was away when the news came out that the City wanted to refinance some $78 million in debt in the hope of getting $3 million in savings. I honestly couldn't quite figure where they were going to get that much NPV savings out of the deal given interest rates these days. Yesterday the PG had an early story online about how they wanted to do this deal on Thursday.. Funny thing is that I have not seen any preliminary official statement released as yet for such a bond and so I still can't quite figure what debt they thought they were going to refi. I was also confused because it was just a few months ago the city said they were not going to be playing in the bond market at all and I quote "for a number of years" (emphasis added). I am kind of losing track of time these days, but I don't think it's been years. Toland got it wrong a bit I hate to say (sorry Bill) in that the article's main point was that the bond insurance market troubles would likely not have an impact here. but then.....

The Trib then has a fuller version today over the various issues involved, not the least of which is the escalating cost of bond insurance (who in the world ever talks about bond insurance as a policy issue?) all add up to more than the net savings at some point. If the Trib is right they are looking at an $800K insurance cost to refi $78 million which as a % I think is quite a hike over rates ever paid in the past. If the deal itself goes south altogether because of bond insurance costs I think that would constitute a real impact here.

The issue in the end is whether they can get to some minimal savings for the deal to be worth going through with. Why should they need some minimal amount of savings? GFOA (that would be the Government Finance Officers Association) has best practice guidance that you ought not to do such a refi unless you can save 3-5% (and that's NET of costs) in the process. Why? There are a lot of fixed costs to this type of deal including lawyers and in Pittsburgh's case the fees for bond insurance. Bond insurance is an one time up from payment that good for the life of the bond...so it really does not make much sense to be paying bond insurance over and over again which is what happens when you refinance the same debt. It's a good deal for the insurer though which sees its potential liability liquidated after only a short time. and the legal beagles always get their fees of course each time a deal like this is engineered.

These transaction costs add up if you wanted to refi over and over again and it does not make sense to pay them if there is a better chance you can get a better deal in the future. That is not to say that the city is required to follow such guidance. When the city refinanced $200 million in 2006, the net savings were only $3 million or so which really came out well below 3%, but who really noticed? It also makes me wonder which debt they are going to refund if they expected $3mil in savings out of $78mil in debt. Also, in the 2006 refi there was $3mil or so in transaction costs in that deal as well, so the lawyers and insurance companies came out almost as well as the city did in the whole deal.

But the Trib article highlights something that is only recently hitting municipal bond insurance markets across the country, namely that this type of insurance has been escalating in price. No big secret since the bond insurance market has been collapsing and econ 101 tell you that when supply shrinks prices go up right? This may be the biggest public finance policy issue these days despite being too esoteric to talk about in the media.

Consider the irony that five years ago the bond insurer FSA felt it necessary to issue a statement that it did not have any exposure to City of Pittsburgh debt following a downgrade of the city's debt rating. It's a bit interesting to see how the circumstances have switched of late. How much exposure do any local governments have to FSA is the question I have these days.

From lots of sources you can read about the implosion in the municipal bond insurance market. Last month the specter of ratings downgrade of two more of the major bond insurers could hit home. Some big bonds issued locally are insured. In some cases it does not matter. For example, if a fixed interest bond is insured by a company that has its rating downgraded, the loss is mostly likely borne by the buyer of the bond. Where once they bought a bond with a high rating, they now own a lower valued bond. I actually wonder a bit if some of the older debt issued by the city of Pittsburgh which was insured by the insurers having trouble is part of the debt that they want to refinance.

But for a lot of variable rate bonds insured by a bond insurer having troubles it's another story. For bonds where the interest rate gets reset periodically and which are insured, the downgrade of the insurer means that the bond is worth less, thus the interest rate it will pay out will be pushed up, thus forcing the borrower to pay out more. In some cases bond issuers also hedge their risk buy buying appropriate instruments that go up in value if the bond value goes down. Typically these instruments hedge against general market risk in the municipal bond market. I don’t think there are many cases where they hedge out the risk of bond insurers going belly up or otherwise seeing their credit rating downgrades.

So who cares? As I explained ad nauseum on the bonds issued by the Sports and Exhibition authority for the bonds issued to pay for the new arena, some local bonds are insured by FSA. FSA has thus far not been hit by the turmoil hitting its competitors such as MBIA and AMBAC, both of which used to be large municipal bond insurers. The news of late is that FSA may have its credit rating downgraded which is going to directly hit the SEA bonds, but also some recent bonds issued by the Pittsburgh Water and Sewer Authority. I wonder what else out there could potentially be hit, there being lots of public debt issued by both large and smaller issuers. Again, lots of existing issuances will not be impacted. Only in cases of variable rate bonds insured by companies being hit by downgrades. However for new issuances, Pittsburgh's current experience is showing how heightened bond insurance costs are really hitting the bottom line. Since a lot of local public finance relies on new debt being issued regularly, this is a real issue.

Don’t think this is an issue? It is across the country. You can read about how this is impacting public debt in places such as Louisville, Los Angeles, and Dallas, among many many others. Are there really no local versions of this story as yet?


Anonymous Anonymous said...

Figured I'd get your attention with a comment at the ultra-wonk post ...

Free Jero concert at Pitt!


See you in the middle of the mosh pit.

Tuesday, August 05, 2008 11:05:00 AM  

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