Recently, a disturbing trend emerged with regard to prices on municipal bonds. With the timing of new fiscal budgets approaching, the spotlight on municipalities unnerved investors:
Source: Distressed volatility.com
Variable Rate Debt Obligations
Not to be outdone the municipal Variable Rate Debt Obligation Market stepped into the spotlight. Variable rate demand obligations (VRDOs), also called variable rate demand notes (VRDNs), were floating rate instruments with terms of as long as 40 years. They paid interest monthly or quarterly based on a floating rate that was reset daily or weekly based on an index of short-term municipal rates. VRDOs were purchased at par. Liquidity was provided with a put feature, which allows the holder to put the security for par plus accrued interest on any interest rate reset date, usually with one or seven days notice. In addition municipalities paid a fee to a “Liquidity Provider”. This “provider” acted as a stand by and in exchange for the fee agreed to purchase any unsold bonds. A re marketing agent—a bank or other entity—served as liquidity provider. VRDOs were put back to it rather than the issuer. The re marketing agent tried to resell those VRDOs or, failing that, held them in its own inventory. VRDOs almost always had credit enhancement—either a letter of credit from the re marketing agent or bond insurance. The issuer generally had an option to convert a VRDO to a fixed rate instrument. Due to the put feature, tax-exempt money market funds generally could hold VRDOs.
Sounds pretty simple right? Short term debt issued and floating at that with maturities up to 40 years!
The 3 month LIBOR rate from December 1999 to December 2010 ranged from nearly 7% to slightly above zero. From December 2006 the rate ranged from about 5.25% to slightly above zero.
The following excerpts come from a testimony by David W. Wilcox, Deputy Director, Division of Research and Statistics of the Federal Reserve Board of Governors on May 20, 2009:
The financial crisis has strained the market for municipal debt, as it has so many other markets. One source of this strain has been that losses on a range of non municipal credit exposures have greatly diminished the capacity of financial guarantors to write new policies and have reduced the perceived value of previously written policies. The share of newly issued municipal bonds that are insured has fallen from about 50 percent in the fall of 2007 to about 10 percent in the first quarter of this year, and the market for reinsurance for such bonds is largely closed. Another source of strain has been that liquidity support for VRDOs has become more expensive while support for ARS has essentially disappeared. Yet a third source of strain has been that the recession has significantly reduced the revenues collected by many municipalities, in some cases by enough to raise concerns about their ability to service their debt.
Although the market for fixed-rate municipal debt is currently functioning fairly well, the markets for floating-rate municipal debt are in more serious condition. Auctions of ARS began to fail enmasse in mid-February of last year. Many municipalities have reportedly succeeded in refinancing ARS into VRDOs or traditional fixed-rate debt, bringing down substantially the volume outstanding in the ARS market.
Strains in the market for VRDOs began to emerge in late 2007, largely in response to increasing concerns about the financial strength of guarantors that insured many of these bonds, and came to a head in September 2008. One commonly used measure of the interest rates paid on high-quality VRDOs skyrocketed from less than 2 percent on September 10 to almost 8 percent in just two weeks. Since then, however, this measure has reversed its September spike and, indeed, has fallen with other short-term rates to below 1 percent. Nonetheless, market participants report that the cost of liquidity support from banks has risen sharply. As in the market for long-term fixed-rate debt, higher-rated municipalities are reportedly able to issue new VRDOs, but many lower-rated issuers appear to be either unwilling or unable to issue debt in this market at the prices that would be demanded of them.
Demand for some VRDOs has reportedly been so weak that the securities have been put to their liquidity providers, turning them into what are called "bank bonds." Under the terms of issuance, bank bonds typically carry penalty interest rates and can eventually be subject to accelerated amortization. The combination of these two factors can cause a sudden and substantial increase in the debt service payments required of the municipality that issued the bond. One market observer estimated that the value of VRDOs that are bank bonds may be about $50 billion, but precise estimates are not available.
The municipalities that issued the securities that have become bank bonds potentially face significant financial difficulties. As noted, if they do not refinance the bank bonds, they must pay higher interest rates and confront the possibility of having to amortize the debt over a much shorter period. But refinancing is not an easy option either, partly because VRDOs are often paired with interest rate swaps that would be quite costly to unwind in current market conditions and partly because banks have significantly increased the fees they assess for new liquidity support, especially for lower-rated issuers.The sharp decline in the volume of VRDO issuance from the peak in 2008 through 2010 speaks volumes. We see a drop from over $120 billion in annual volume to roughly $10 billion. That is a drop of 92%!
VRDOs and Interest Rate Swaps
Trouble in the short-term municipal-bond market resulted in financing headaches for many municipalities, especially as their revenues declined from 2007 - 2009. Any municipality with less than sterling credit potentially faced higher funding costs and less access to credit. Compounding the problem, most municipalities that relied on short-term funding also entered into interest-rate swaps to hedge their interest-rate risk; in the aggregate, they have lost billions of dollars. To refinance would mean closing out the swaps and recognizing the losses — something no politician is eager to do.
The situation was so dire that the treasurer of California and representatives of 19 municipalities in the state wrote to congressional leaders seeking help in persuading the Federal Reserve to develop programs for enhancing the muni markets' liquidity. Their letter directly addressed the deterioration in the so-called variable-rate-demand-obligation, or VRDO, market. The market, which is estimated to be about $500 billion, experienced 2 key difficulties in 2009. At the start of the year many monoline insurance companies were downgraded below double-A, which required money-market investors to put the securities back to the banks. Then some of the banks providing letters of credit, such as Dublin-based Depfa Bank, were downgraded. Other LOC providers (think Lehman Brothers) disappeared, and still others racked up losses elsewhere, making them less willing to rent out their balance sheets and more likely to charge higher rates for the privilege.
It is hard to calculate the amount of VRDOs put back to banks, in part because there were so many issuers. Some market players estimate the total at $50 billion, or 10% of the market. Banks left holding VRDOs often boosted their interest rates to punitive levels, and terms stipulated that the maturities could shrink to four or five years. These developments encouraged many municipalities to replace VRDOs with alternate forms of financing. Now the OTHER problem: Some industry insiders estimate issuers of more than 70% of VRDOs also entered into swap agreements to pay a fixed interest rate and receive a variable rate, thus guaranteeing their cost of financing. The drop in short-term rates led to a decline in the market value of the swaps, and the cost of canceling them has risen. To refinance the VRDOs, they needed to terminate the swaps, and recognize any losses on the swap contracts.
Municipalities have lost about 10% of the value of outstanding swaps, observers say, which means they are sitting on unrecognized losses of $35 billion. The swaps often have the same 30-year maturity as the VRDOs, so if rates subsequently rise, the losses will be erased. Many have replaced outstanding auction-rate securities with variable-rate demand obligations. The state of California had $1.75 billion of letters of credit up for renewal in the second half of 2009 and $91 million of VRDOs that found no buyers and were put to the banks. The state has also paid 7% to 10% on its $1.3 billion of commercial paper in the past two months. That rate is usually 1% to 2%. The Bottom Line
Financing costs for municipalities with credit ratings that are less than sterling headed higher as troubles in the market for VRDOs continued through 2010. The state of California suggested the Federal Reserve either purchase the variable-rate demand obligations sold back to the banks, or make direct loans to the banks so they have the capital to buy VRDOs.
And What about those Interest Rate Swaps?
It appears that “Buyer's Remorse” has prompted many city and state officials into wondering about “Interest Rate Swap” or “Exchange Rate Agreement” transactions with Wall Street investment banks during the frothy days of 2002 -2007. Hundreds of U.S. municipalities have lost considerable taxpayer dollars on interest-rate bets they made during the great bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts. The Los Angeles city council approved a measure in March 2010 instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's waste water system has now cost the city about $20 million a year. In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to June 2010. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. Government agencies that saw the transactions as a cushion against fiscal surprises felt the squeeze by such derivative transactions. The supply of municipal derivatives increased to more than $500 billion in 2008 before falling in the past two years, according to the research firm Municipal Market Advisors. Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs. The swaps were supposed to be cheaper than traditional fixed-rate debt.
The swaps, promised to pay a fixed rate to banks, often 3% or more, while municipalities received payments from banks that varied with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.50%. Government budgets, stretched to a breaking point, prompted officials to look for dollars wherever they could.
Escaping the swaps will not be cheap or easy. For example, a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city could lose about $5 million this year. Some deals have led to court. In August 2009, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claimed it was owed $156.6 million under the agreements. The toll authority claim said it made the payment and Ambac sued for the other part of what it says it is owed. Bad Habits Lead to Unhealthy Behavioral Patterns and Cycles
The preceding examples of market instability are just a few of the events that are linked together and were generated from the Subprime Crisis. The link between all of them is the sudden nature with which they developed with one following the other. The ARS and VRDO problems are localized within municipalities and create additional fiscal stress. The aversion to risk created a liquidity crisis and crunch that unfortunately will be felt for years to come. History has shown that financial crises reach far and wide. The contagion effect is virtually uncontainable and unstoppable. The key here is the reliance on debt during good economic time as borrowers fall into a “debt reliability pattern”. When the music stops playing, the dancing stops. Debt then is relied upon even more heavily as revenues decline. Debt service becomes an even larger part of the budget and squeezes spending in other areas. This evolves into a “debt reliability cycle” that exacerbates the ability to continue current spending levels that developed a dependency upon the “debt reliability pattern”.
The solutions are not easy and large sums of federal dollars have been directed towards state and local government for support. This is adds to the debt reliability pattern at the federal level which has obviously continues to feed the “debt reliability cycle”. We know from personal experience that individually we get into good and bad behavioral patterns and cycles. These cycles at the personal level are natural phenomena. It is no different at the municipal level. We also know how difficult it can be to break those bad habits, whether they may be excessive eating, spending, smoking, alcohol consumption and so on. When these bad behavioral patterns move to a collective body of individuals, the pattern appears to get worse before it gets better. It takes a very strong will to break the bad habit pattern.
As individuals we see the pattern and address it with aggressive steps to stop the cycle. This is no different than the steps public officials must take to stop the bad fiscal patterns and cycles we now face. Developing a plan and sticking to it is the key to breaking the cycle. The dysfunctionality of the ARS and VRDO markets means that debt service has been impaired and is likely contributing to increased budget deficits at the municipal level. The discussion above regarding ARS and VRDO markets should send a clear message: keep things simple. First borrow as little as possible. Second, if there is no other choice but borrowing, it must now be linked with a clear new and reliable revenue source. The borrowing must get back to the basics, principal and interest payments clearly laid out. No surprises. No reliance upon questionable derivatives and other linked contractual relationships. Municipalities must develop a self- reliant mentality with a focus on improving balance sheets and ultimately credit ratings.
A Quick Look at the Damage bad Habits can do
9 Decades of Consumer Debt: How Our Debt Problems Got Out Of Control (www.thedigeratilife.com/blog/consumer-debt-problems)
The graphic below entitled “The American Way of Debt” shows the average household debt and annual savings in today’s dollars, throughout nine decades (1920 – present). It’s pretty incredible to see just how much the love affair with personal loans, 0% APR credit cards and mortgages has caused household debt to balloon to unprecedented levels:
There are a few notable aspects here, such as how the annual savings rate during the current decade is the lowest it’s ever been — rivaling only the savings rate during the depression years (1920s – 1930s). Then during wartime years in the 1940s, there seemed to be a peak in savings, with American households saving up to $12,800 a year; this situation was credited to wartime restrictions on credit, but by the end of this period, people went back to borrowing more and saving less.
Over time, note how various debt instruments and products are introduced to the general population. Adjustable rate mortgages pop up in the 70′s, along with Sallie Mae, the largest lender for student debt. The 70′s was also the time when credit card debt began to pick up traction. Then in the 80′s, see how debt shifts to mortgages, and this seems to be the turning point for mortgage-backed securities — when lenders began to transfer some of the risk they were bearing onto investors. And things get progressively worse (debt-wise) all the way to the present time, where we now face these sobering facts:
In the 2000s, debts soar with rising home prices, historically low rates and increased access to credit. Collective household finances have never been worse than in recent years: savings have pretty much evaporated with families saving an average of $300 to $400 a year, while dealing with a debt load that’s as immense as ever. The graph shows that all types of debt increased — from credit card debt and installment loans to home equity loans and mortgages. The average debt load blew past $100,000 and that’s where we are today. The scary thing is that this happened to be the state of consumer debt and savings today, which is only one aspect of the big picture. A bird’s eye view of our nation’s financial situation — the economy as a whole, how our business and government sectors have been operated, the budget deficit — the future seems quite challenging at best.
The Age of Deleveraging
The acceleration of consumer debt over the past 20 years eventually staled out. This chart from the Federal Reserve illustrates how consumer debt has stalled and deleveraging has taken over. As the Financial Crisis spread, consumer credit declined for two reasons: a decline in the availability of consumer debt and efforts on the part of consumer to pay off debt or deleverage:
Consumer debt fueled increased Personal Consumption Expenditures (PCE):
As PCE falls so do revenues for businesses and tax revenues for municipalities. This chart shows PCE turning higher in 2009 and continuing to the present. A particular item of note however: government transfer payments component of PCE:
Government transfer payments now represent more than 20 percent of PCE. Increased transfer payments translate into increased government spending and increased government borrowing and deficits. Clearly the debt reliability pattern is leading to a debt reliability cycle which does not translate into a rosy future.
PCE, The Fed, GDP Sector Contribution and “Economic Recovery”
The preceding discussion represents the connection between all of us, especially during times of economic and financial stress. Much like the human body, when placed under stress, the weak links in financial markets become more pronounced. Subprime securitizations, ARS, VRDO and interest rate swaps are all derivatives. This is my personal opinion and I am sure there are those who disagree. The “Debt reliability Pattern” and “Debt Reliability Cycle” continue. This eventually will lead to future deleveraging and reduced PCE. Transfer payments inevitably will end and even before that PCE will be closely watched as government participation bloats PCE and “Real PCE” actually declines:
In order to experience healthy real economic growth, transfer payments must decline. As the consumer deleverages the efforts towards getting back to ground zero will face severe headwinds in the years ahead. There is no real evidence that transfer payments will decline substantially. As consumption historically accounts for nearly 70 percent of GDP, a lack of increase in real PCE does lead to deflation concerns. Once deflation hits, debt deflation becomes a very real problem and a very severe concern for policy makers. This is the primary driver of persistently high unemployment and the Federal Reserve. This is, I believe, the main reason behind QE2 from the Fed.
The Fed’s decision to engage in QE2 has been highly criticized, but given the structural problems in the U.S. economy, the Fed is attempting to fuel a consumer revival with unemployment at 9.6%.Over the past 2 years the fed’s attempt at fueling a recovery have not worked in the expected manner:
A Money Multiplier below 1.0 means that QE1 did not work. The actual result of QE1 is a surge in bank Excess Reserves held in reserve accounts at the Fed:
Fed policy alone cannot not lead to the “right mix” of all components of GDP:
This chart illustrates the historical sector contribution to U.S. GDP. While 2010 is not shown, the structural changes are evident. For 2010 we see the following on the far right:
The contributions from all sectors have struggled to return to historical norms. Consumer spending has been restrained by high food and fuel prices. More spending on food and fuel means less spending on other retail and durable goods. This means less revenues for state and local governments. In the age of deleveraging this is the true challenge for the United States economy. The implications are that this will also be the running theme for state and local economies. One may very well come to the conclusion that the norm that developed over the last 30 years was supported by consumer overleveraging and the future composition with deleveraging will look quite different. In addition, deleveraging leads to deflation which in turn leads to debt deflation. Debt deflation has historically been a significant impediment to economies in recovery mode after a major financial crisis.
The Scourge of Debt Deflation
Don't Look Now, But We're REALLY Close To A Deflationary Relapse
Joe Weisenthal
Dec. 15, 2010
This morning the government reported that core-CPI -- which excludes food and energy -- rose 0.1%, suggesting perhaps a move away from the deflationary brink. But really it was all energy that pushed prices higher, and energy has a lot to do with what's happening in Asia, and not necessarily reflective of the domestic situation. Take that out, and keep in food, and this is what you get.
INFLATION, WHERE IS THY STING?
By David Rosenberg
December 16, 2010
Here we have a booming commodity market with the CRB index experiencing a classic triple-top, and yet, underlying inflation is barely existent. Headline inflation came in at a mere +0.1% M-O-M and the Y-O-Y inflation rate is at a paltry 1.1% rate. The core CPI (which excludes the effects of food and energy) was up by less than 0.1% M-O-M and the YoY, at 0.8%, is actually overstating things because the three-month pace is running at a tiny 0.4% annual rate. And this is occurring despite a 3% growth economy, massive fiscal and monetary steroids, and what has been for the most part, a squish-soft U.S. dollar and surging raw material prices. If any or all these developments shift into reverse for whatever reason, then at the least a mild deflationary backdrop is sure to ensue. While there is concern over bond supply from the fiscal largess, make no mistake — inflation is twice as important for the direction of long-term interest rates.
The deceleration in inflation is very broad based and becoming increasingly apparent in services — hospital services (-0.2%), movie admissions (-0.2%), education/communication (+0.1%), personal care services (+0.1%), restaurants (+0.1%), and vet services (-0.1%). Service sector inflation has come all the way down to +1.0% YoY and we have goods up 1.4% YoY. But again, what if the goods segment begins to deflate if the commodity boom takes a rest and we see a sustainable Eurozone-induced rally in the greenback?
Oh yes, for all the economists out there who were warning us that once the rental component of the CPI began to stabilize we would start to see the core inflation rate kick higher … think again. Core excluding shelter CPI barely rose at all and the Y-O-Y trend is all the way back to where it was three years ago, at +1.2%.
Irving Fisher on deflation:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worth of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
As debt levels have climbed at the state and local level, debt service, variable or fixed will actually increase as deflation takes hold. The next 5 -10 years will be either very painful or, well, very painful. The real protestss shouldn't be regarding collective bargaining, but making phones ring off the hook about massive and totally irresponsible levels of government debt.
Robert Crossen
March 11, 2011
