Interest-rate swaps cost public agencies millions of dollars. Now they’ve largely disappeared in the public sector.
Many agencies have paid money to get out of swaps deals. SANDAG, however, has kept the bulk of its swaps – with their outsized monthly payments to banks on top of debt payments to actual bondholders – even as money runs dry for new projects.
The state budget crisis continues to harm all of Illinois with harsh financial impacts, and Chicago Public Schools are finding themselves in the middle of the unbalanced books.
Recently, CPS were forced to borrow money at interest rates far higher than a typical government would permit.
Relying on borrowed money for the rest of the school year, the cost of the latest loan comes with an interest rate four times higher than a state government with good credit ratings would see, according to the Chicago Sun Times.
A week after borrowing $375 million from J.P. Morgan at a rate of 6.39 percent, CPS secured another $112 million from the same lender at 6.41 percent.
Democrats have quietly, and with little scrutiny, embraced a key component of Gov. Chris Christie's fiscal agenda, even as they feud over the details of a drug treatment bill at the center of budget negotiations that must be complete by Friday at midnight to keep New Jersey's government running.
Christie's plan to shift the lottery proceeds to help fund public pensions has been touted as an innovative and pain-free way to inject steady revenue to the nation's worst-funded pension system and instantly reduce its liability.
But there are still concerns over what the shift may mean for the social service programs that the lottery was established to help. And it remains to be seen what the real effect of the legislation would be on the state's creditworthiness should the bill pass.
The Chicago public school system has borrowed the hundreds of millions of dollars it needs to start the coming school year, at interest rates about four times what a typical government with better credit ratings would have to pay.
The Chicago Sun-Times reports that a week after the school district borrowed $375 million from J.P. Morgan at an interest rate of 6.39 percent, it secured another $112 million from the same lender at 6.41 percent. The short-term borrowing known as “grant anticipation notes,” eventually will be repaid by state block grant money owed to the Chicago district but not yet disbursed because of the ongoing budget stalemate in Illinois.
S&P Global Ratings on Monday delivered a two-notch downgrade to National Public Finance Guarantee Corp., and affirmed its AA ratings on both Build America Mutual, which had earlier been placed on negative watch, and Assured Guaranty.
S&P said it lowered its financial strength rating on National to A from AA-minus and its long-term counterparty credit rating on its parent company, MBIA Inc., to BBB from A-minus. MBIA's financial strength was affirmed by S&P at CCC.
Some market analysts said the cuts will prevent National from writing new business, which would leave only two active bond insurers.
Underfunded pension plans grab the headlines. But that’s not what drives prices in the municipal bond market, according to Tom Doe. It’s the interplay between supply and demand – and right now yields are depressed due to a shortage of high-quality bonds.
“It’s all about investing the massive amount of money coming into this sector,” Doe said. He added that this is the biggest supply shortage since the fall of 2013.
Doe is the founder and chief executive officer of Concord, MA-based Municipal Market Analytics (MMA), an independent research firm that provides strategic market and credit research on the U.S. municipal market and industry. I spoke to him on June 23.
• Interest-rate swaps cost public agencies millions of dollars. Now they’ve largely disappeared in the public sector.
• Many agencies have paid money to get out of swaps deals. SANDAG, however, has kept the bulk of its swaps – with their outsized monthly payments to banks on top of debt payments to actual bondholders – even as money runs dry for new projects.
It was 2005, and the recession hadn’t hit yet. Most taxpayers didn’t have opinions on financial derivatives. Few imagined major banks could ever go belly up. Even government agencies began drinking the Kool-Aid.
The San Diego Association of Governments was no different. Looking to maximize the possibilities for TransNet, its newly passed sales tax measure, the public agency did what others were doing: It played around with sophisticated financial arrangements that few understood.
SANDAG bet big that interest rates would go up. Instead, rates went down and stayed down – they’re still down. That unforeseen event – persistent and historically low interest rates – cost the agency millions.
As a result, SANDAG now has a roughly $100 million liability hanging over its head. It’s already spent $3.5 million out of pocket that it didn’t anticipate. And it spent $22 million to get out of a portion of its bad bet using borrowed money that will end up costing $42.5 million to repay.
The pension fund would get the same $1 billion from the lottery or state budget. But for accounting purposes, the money counts more if it is being produced by an asset of the pension fund. So – presto chango! – the state’s unfunded liability would drop by $13.5 billion, says the Treasury Department.
This would only matter if it prompted debt-rating agencies to upgrade New Jersey (after years of downgrades) and reduce its borrowing costs. The bond analysis firm Municipal Market Analytics told Observer New Jersey that is unlikely. Sen. Jennifer Beck, R-Monmouth, sensibly prefers to hear from Moody’s or S&P before voting on the lottery plan.
But small investors can incur hefty trading costs even in higher-quality, less-obscure bonds. Research firm Municipal Market Analytics offers this example: Looking at a California general-obligation bond maturing in 2037, there were two inter-dealer trades on the morning of March 17 at nearly the same price: $112.73 and $112.67. Three minutes later, a customer bought $50,000 worth of the bonds at $115.10—2.2% more. Less than an hour after that, a large investor buying $6.9 million worth of the bonds got something much closer to the inter-dealer price: $112.99.
Such price discrepancies can make the muni market "very difficult for an individual investor," says Thomas Doe, president of Municipal Market Analytics. The market actually resembles a "flea market," he says, "because you have this eclectic product, very inconsistent supply and demand, and you're just trying to match the product with a buyer."
Matt Fabian, a partner at Municipal Market Analytics, said the 6.39 percent interest rate is about 4.5 percentage points “more than a ‘regular’ issuer would pay, but CPS left ‘regular’ two years ago.
“CPS has no regular market access so the price they pay to borrow is always the product of negotiation,” he added.
Investors purchasing the American Dream bonds will need to weather the potential pitfalls: The 1,136-page offering statement includes 36 pages of risks, ranging from whether the project will be completed on time to the “difficulty, expense, unfamiliarity and time-consuming nature" of getting to the center.
American Dream is across the highway from MetLife Stadium, the home of the National Football League’s New York Giants and New York Jets. Events at the stadium could adversely affect attendance.
Lisa Washburn, a managing director at Municipal Market Analytics, was skeptical that tourists coming to New York, with all of its culture, entertainment and shopping, would get on a train or bus to the Meadowlands, “a difficult to-get to destination in a relatively unattractive part of New Jersey."
“Parking and transportation is really substandard in this area," said Washburn.
New Jersey Gov. Chris Christie’s proposal to used dedicated state lottery revenues to boost its underfunded pension system is not a viable solution, according to Municipal Market Analytics.
Christie has pushed the lottery plan since his February budget address arguing that that it would lead to an immediate $13 billion improvement in the pension fund’s unfunded liability. However, MMA partner Matt Fabian noted in a report released Tuesday that the proposal
Analysts and advocates say the deal — an arrangement that would be unique to New Jersey — probably won’t hurt, but there’s not a consensus on how much it might help.
“Where it does provide tremendous relief is optically,” said Lisa Washburn, managing director at Municipal Market Analytics, a firm that analyzes government bonds. “The numbers look better on a whole lot of levels. Whether or not they’re truly better is questionable.”
Since Christie took office in 2010, the state has contributed more than $6 billion to retirement funds to which past governors have often skimped on payments — or skipped them entirely. Still, the gap between the money expected to be in the funds and that which is owed to retirees has only grown. By any measure, it’s among the biggest unfunded pension liabilities in the country.
Since that filing, the 50- and 200-day moving averages for daily trade volume have increased by 17 percent and 6 percent, respectively.
“It has become more clear that there isn’t much money,” said Matt Fabian, a partner with Municipal Market Analytics Inc. “Maybe Puerto Rico investors were too optimistic in what they thought the control board would do or what Puerto Rico could theoretically pay them.”
While the securities are easily sold, some are still hovering near record lows.
Sixty-nine percent of American Dream's 2.9 million square feet of space has been leased to tenants like Saks, Lord & Taylor, and Primark. There will also be a Nickelodeon amusement park and a DreamWorks water park.
Still, says Lisa Washburn, a credit research analyst for Municipal Market Analytics, the project should give any investor pause.
“I still remain skeptical about the ability for success for the project generally and specifically very concerned about the risks to bondholders,” she said.
Illinois also would have to make millions of dollars in termination payments on existing interest-rate swap contracts, according to S&P. Those penalties would be about $10 million in the event of a downgrade to junk by one rating firm, would reach $19 million if two firms gave the state a junk rating and could reach $108 million in the event of further downgrades.
"By letting the state get downgraded, Illinois's government is only making its own budget problems worse," said Matt Fabian, a partner at Municipal Market Analytics
Analysts for all three ratings firms have said that Illinois has significant economic strengths and that its deteriorating credit is in large part a result of political gridlock.
Distressed muni-debt traders usually buy when the credit rating of a bond is downgraded to junk status. That’s when institutions, such as mutual funds, are forced to sell or otherwise long-term retail investors get spooked.
“Next time around, you bet that they’re going to be asking for lower prices when mutual funds want to unload something like Illinois,” said Matt Fabian, a partner with Municipal Market Analytics Inc. in Concord, Massachusetts.
“How the country will deal with municipal default is likely in its infancy,” Hatch said. “Ideas are forming, from a legislative and judicial standpoint, as to how we’ll handle large insolvent municipal entities.”
The flouting of constitutional rules may cause distressed muni-bond investors to insist on discounts, but it won’t scare them away from the market, Fabian said.
The rally in municipal debt comes as analysts expect supply to continue to shrink in the summer months at the same time that cash-rich investors will have a hoard to invest. Citigroup Inc. analysts predicted that the market will shrink by $39.5 billion between June and August, while investors will receive $44 billion in interest payments.
"Because of the lack of supply relative to demand, and because of the relative height of nominal yields, its going to be hard for munis to project weakness over the summer," said Matt Fabian, a partner with Municipal Market Analytics Inc., in a telephone interview. "Left to their own devices, munis will be prone to rally."
Some local governments have a hidden reason to root against President Donald Trump’s tax-cutting agenda: It could make their bank loans more costly, according to Municipal Market Analytics.
Municipalities have borrowed billions from banks to skirt the expenses associated with public bond offerings. But banks often include provisions enabling them to raise the interest rates if legal or regulatory changes diminish their returns. A cut in the corporate tax rate, for example, would likely result in a lower after-tax yield on a tax-exempt loan, potentially triggering “yield maintenance" provisions, wrote analysts at MMA, a Concord, Massachusetts-based independent research firm.
“Given the current administration’s focus on tax-reform and/or tax cuts, borrowers that have these yield maintenance provisions could see their debt service costs rise," MMA wrote.
Direct lending by banks has proliferated in the $3.8 trillion municipal market because states, local governments and non-profits can borrow at rates comparable to those on bonds, without the fees or disclosure requirements associated with securities sales.
Because loans aren’t classified as securities, states and cities aren’t immediately required to disclose them, despite the risk they can pose to bondholders and taxpayers. For example, banks can demand accelerated principal and interest if a payment is skipped or a government’s cash falls below a specific target, which could push the borrower into a liquidity crisis if it can’t cover the bills.
MMA estimates that some $180 billion of such loans have been made. But given the lack of disclosure, it’s impossible to know how many borrowers might be subject to rate increases if federal taxes are cut, MMA wrote.
“Borrowing against uncertain and late categorical funding from the state … may allow the district to remain open through the end of the school year and make its statutory pension payment, but it will come at a heavy price, both in terms of a high borrowing cost and the reputation of CPS. Worst of all, it does not help with the Chicago Public Schools’ budget shortfall next year and will, indeed, make it worse,” Msall said.
Matt Fabian, a partner at Municipal Market Analytics, said CPS is already the “main risk to the city from a triage perspective” and, therefore, the city would have been better off “giving” the district the short-term money it needs.
He suggested the city either borrow the money for CPS or raid the tax-increment-financing (TIF) surplus yet again, just as Emanuel did to the tune of $87.5 million to stave off another teachers strike.
“That’s a better option than paying 8.5 percent interest and taking more risk. There’s no reason to assume that the state grants are gonna be provided anytime soon,” Fabian said.
“The problem for Chicago and CPS is that the state is simply not going to help or the state is unwilling to help. So, the city and the school district need to work out plans of their own. Because they continue to rely on the state, they keep winding up in this same situation.”
Fabian urged Emanuel to move quickly to identify a permanent, local source of revenue for the Chicago Public Schools.
“Speaking for Wall Street, the street is impatient to get to a full-funding scenario. Investors want the long-term solutions produced in the short-term. As far as figuring out what taxes to raise and what spending to cut, full speed ahead,” he said.
The Chicago Sun-Times has reported the mayor is considering taxing high net-worth individuals, downtown businesses or both to generate the $400 million-to-$600 million needed to put CPS on more solid financial ground.
“That is one of the easiest things for Chicago to tax because they have had strong growth downtown. That would seem one of the more resilient areas of the economy to tax. It’s not unreasonable to look there first,” Fabian said.
“There isn’t much tax capacity in the neighborhoods and, from a national perspective, Chicago’s economy is very healthy. So, it could handle a higher tax burden, especially downtown.”