Tuesday, March 10, 2009

bonds under water

I don't have anywhere near the time to figure out exactly what is going on with the PWSA bonds that were in the news yesterday. The problem as best as I can figure is not exactly what I warned about last fall for either the variable rate PWSA bonds, or the variable rate SEA bonds. Think it's not at least potentially a big deal. In Alabama, the Jefferson County Sewer system system is deep into bankruptcy proceedings that also stemmed directly from variable rate bonds gone awry.

Some general questions this all raises beyond the political fireworks. What are the legal liabilities that fall back on the City of Pittsburgh if the PWSA, or any of the city authorities for that matter, run into dire circumstances? I would suggest that is not a fully answered question that impacts a whole lot of things in town here. More important than the details of this one bond deal.

But on this particular issue in the news. The professionals are better at explaining the heart of the problem here in a finite number of words. For the less feint of heart you can read the whole bond prospectus here:


Maybe we will throw in here for good measure the obvious question of why things like this bond prospectus are not put up on the PWSA web site?

I can't find anything in the bond prospectus to explain the current machinations. Further detail has to be in other covenants somewhere that are less available to the public. But here are some things to consider. Not too long ago the School District of Erie sued JP Morgan over some similar interest rate swap deals that went south. Is the PWSA considering similar litigation in its case which involves a much larger sum than what was in play in Erie? What is also worth noting is that JP Morgan got out of the muni bond interest rate swaps bond business not long ago. The PWSA deal may actually have been one of the last such deals they got involved with. Think about that a bit.


Anonymous Anonymous said...

Good post Mr. Briem. The worst thing about this swap is that JP Morgan does not disclose how much money they made in total. Sure they disclose the underwriting fees, but not the fees associated with the swap itself. Trust me on this, they walked away with millions. The city should have taken in much more than the $98 million they recieved for entering the swap.

There is a reason JP Morgan ended to their involvement in swaps - it exposed them to bad press and lawsuits. On behalf of PWSA customers, the city should take them to court.

Tuesday, March 10, 2009 12:36:00 PM  
Anonymous Anonymous said...

5607(e) of the Municipalities Act prohibits any authority from pledging the credit of Pennsylvania or its subdivisions, which usually includes cities. However, this doesn't prevent the city from pledging to stand behind the bonds in the covenant documents.

Tuesday, March 10, 2009 3:29:00 PM  
Anonymous Anonymous said...

For a second, I thought you were recommending some kind of super glue. But, I'm more than a little irked about this. Our water use is down (new, efficient appliances) and our water bill is close to double what is was a few years ago.

Tuesday, March 10, 2009 8:49:00 PM  
Blogger C. Briem said...

Broadly speaking I would think there are other ways risk could be passed on to the city. Think of all the negative consequences if PWSA really went bankrupt. but good point.

Wednesday, March 11, 2009 1:10:00 AM  
Blogger Felix Dzerzhinsky said...

Chris -- What's the difference between this form of variable rate swap on the one hand and an auction-rate security on the other? Dexia is saying they will no longer guarantee the weekly bond sales starting in June; is there a relevant difference between this and the banks' sudden failure to guarantee the interest rates on the resale of auction rate securities, a crisis that began in late 2007/early 2008, before these PWSA bonds were approved?

In other words, given the collapse of auction-rates, should there have been reason to suspect that other complex credit arrangements for munis would fail as well?

Thursday, March 12, 2009 8:57:00 AM  
Blogger C. Briem said...

It does make you wonder if they would have tried to set this up as an auction rate security if they could have, and what situation they would be in now if the auction rate market had just failed later. In a weird sense, they are saved from a slightly worse scenario only because that worse scenario was eliminated just before they went into this bond.

I may not have this fully correct, but basically ARS securities can't be reverted back to the issuer on demand. If a holder can't sell the debt to someone at auction (i.e. when an auction 'fails') they get a higher 'penalty' rate that most would be glad to receive.. but they can't get their principal back early. Thus the risk is the bond issuer may have to pay a really high interest rate, but in no case are they on the hook to pay out the full amount of the bond.

The variable rate bonds at issue here can be sold back to the issuer on demand pretty much. the bond issuer is thus on the hook to be able to provide a large amount of cash that they probably don't have. Thus there is a need to pay banks in order for them to agree to be willing to provide the cash if needed. The willingness of these banks to fill that role is what is at issue here.

The distinction? As I understand it JP Morgan is unwilling to be the bank lending facility per the terms of the original bond.. but are willing to do so for a much higher rate.. It seems to me they are attempting to blur the distinction between the ARS and variable rate bonds like this. They are essentially saying they are willing to take the 'penalty rate' that may have been in place in an auction rate market. It's not a complete analogy... but the auction rate market failed when the banks that 'made' the market were unwilling to buy bonds even at higher rates. Here JP Morgan is saying it really wants a premium to be that buyer of last resort.

It seems that the deal with the banks was set up to be an annual contract.. thus every year the contract had to be renegotiated. The chance that banks would be unwilling or unable to renegoatiate that role is called 'renewal risk'. Its one of those risks that the markets discounted in the past a lot more than they should have. Whoever cared much for counterparty risk as they do now. So what I really want to know is whether this is happening elsewhere. Certainly not the only bonds like this out there. Are these banks pulling out elsewhere or is it just here. Just have not had time to look at that.

Thursday, March 12, 2009 9:49:00 PM  
Blogger Felix Dzerzhinsky said...

I think I understand your explanation, but is this true?

"I may not have this fully correct, but basically ARS securities can't be reverted back to the issuer on demand."

If I recall correctly, UPMC was able to buy back all its auction-rate securities after only one week of being gouged after the bottom fell out. They were one of the first to do this anywhere, so it made the national news. Of course they were able to do this because they had enough capital to be able to buy them back, and probably not all issuers/obligors had that kind of capital . . .

Friday, March 13, 2009 8:28:00 AM  
Blogger C. Briem said...

I had thought this whole ARS thing had come about after I left Lehman which was some time ago.. but it seems they were around but much smaller markets than now. I just never dealt with this at all.

But here.. the issuer (UPMC) obviously had the right to call the debt and pay it off.. its the right of the buyer of the debt (the bond holder) to force them to do that which is the distinction I am pretty sure. I suspect the holders of UPMC's debt would have been quite happy getting that 'penalty' interest rate forever.. which is obviously why UPMC went to lengths to refinance it since they were paying out the lucrative rates. In the debt issued by the PSWA and lots of others the bond holders have the right to demand their money back if they can't sell the debt otherwise. (the details of when they can or would want to is obviously more detailed than that.. but that's the big difference with ARS).

I'd have to look closeer to see what rights the PWSA has to call the debt and refinance. One hopes they can or else they are in a worse negotiating position with regards to getting this bank financing deal in place with either JP Morgan or somebody else.

Friday, March 13, 2009 9:24:00 AM  
Anonymous Anonymous said...

Well, if this works out, the PWSA will be in a much better position if they choose to negotiate with JP Morgan.

Friday, March 13, 2009 11:58:00 AM  
Anonymous Anonymous said...

"For the less feint of heart...."

Isn't it likely that the more feint of heart (who love fraud presumably) would relish the doublespeak of the prospectus? The FAINT of heart are the rest of us PWSA customers, contemplating what our monthly bills will be if this bond deal implodes.

Saturday, March 14, 2009 6:40:00 PM  
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