New York Faces Double Whammy as Swaps Compound Failed Auctions
By Michael Quint
Feb. 28 (Bloomberg) -- Local government officials from New York to Houston who followed the advice of their bankers and issued auction-rate bonds in combination with interest-rate swaps are now getting squeezed by both.
States, cities and hospitals across the country expected yields on the debt to move in tandem with benchmark rates when they bought swaps to protect against rising interest costs. Instead, the bonds' rates are up an average 3.1 percentage points since September, while the one-month London interbank offered rate -- what banks charge each other for funds -- has dropped 2.7 points.
``It's a universal problem,'' said Debra Sloan, director of capital markets at Boston-based Partners Healthcare System Inc., which has interest-rate swaps on $450 million of its $600 million in auction securities. ``We try to structure them so that over time there is a match.''
The failure of the financial instruments compounds the pain for borrowers stuck paying record-high interest on auction-rate debt billed as a cheap alternative to traditional bonds. Investors got skittish last year, retreating from auctions that determine new rates every seven to 35 days. Now UBS AG, Goldman Sachs Group Inc., and other brokers are refusing to be bidders of last resort, and the $330 billion market is frozen.
Municipalities and their taxpayers are paying for swap agreements that haven't worked for months.
Diverging Rates
The contracts typically require buyers to pay fixed rates in exchange for variable payments from the banks arranging them. These variable rates, based on Libor, roughly matched the cost of auction bonds for more than five years, making the fixed rates -- still far lower than what borrowers would have paid on traditional bonds -- well worth it.
Then, when a crisis in the subprime mortgage market began to shake investor confidence in September, they started to diverge.
The annualized rate on $63 million of auction bonds the city of Buffalo, New York, sold in 2005 jumped 7.7 percentage points when a Feb. 14 auction failed, triggering the penalty rate of 11 percent proscribed in the terms of the deal. That's almost 9 percentage points more than the floating rate it got from a swap with New York-based Citigroup Inc. Adding in the fixed rate of 3.17 percent, the city paid more than 12 percent that week.
``It hasn't always been like that,'' said Anthony Farina, executive assistant comptroller in Buffalo.
Before rates soared, Buffalo had about $400,000 saved because the variable interest on the swap exceeded its payments on the bonds, Farina said. That cushion is shrinking because in the week after the Feb. 14 auction, it paid $134,803 in interest on the bonds and received $26,753 from the agreement. The fixed- rate payment was $38,875.
Cheap Financing
Auction-rate bonds are a way to tap short-term interest rates without having to repay principal for decades. They were one of the cheapest forms of tax-exempt municipal debt until the September change in demand coincided with the first cut in the Federal Reserve's target rate in four years.
Securities that reset weekly yielded an average 83 basis points less than 20-year fixed-rate debt in the 16 preceding months, a comparison of indexes compiled by the Bond Buyer and Securities Industry and Financial Markets Association showed. For other variable-rate securities, it was a difference of 10 basis points. A basis point is 0.01 percentage point.
Auction Failures
Hundreds of auctions failed this month as banks that managed the bidding refused to pick up the slack for investors. After $163 billion of losses on debt holdings tied to the riskiest subprime mortgages, the world's biggest financial firms are less willing to make purchases for their own account.
Spokespeople at New York-based Goldman and Zurich-based UBS declined to comment. Dealers used to routinely step in when needed, though they aren't obligated to support the auctions they run.
When there are no bidders, rates revert to penalty rates spelled out when the debt is issued. Even successful auctions are producing yields more than twice that of fixed-rate borrowing benchmarks.
Since Sept. 9, the average seven-day auction rate rose to a record 6.89 percent from 3.88 percent, according to the Securities Industry and Financial Markets Association. At the same time, one-month Libor dropped to 3.12 percent from 5.82 percent as the Fed lowered its rate for overnight lending between banks 2.25 percentage points.
``Right now, the auction rates aren't matching up very well with swaps,'' said James Moncur, deputy comptroller for Houston, which has $1.9 billion of auction debt outstanding, including $653 million tied to swaps. ``We are still better off than if we had done fixed-rate bonds, but the advantage is shrinking.''
Past Savings
New York state's borrowing costs over the five years through March 2007 would have been $176.9 million higher if it had sold conventional fixed-rate bonds instead of going to the auction-rate market and entering into swaps, according to a state report.
Now New York state has $3.5 billion of swaps associated with its $4 billion of auction debt, and all of the bonds cost more than the variable rate that banks including Goldman, Merrill Lynch & Co. and Lehman Brothers Holdings Inc. are paying on its swaps.
Among 57 auctions held on New York's bonds between Feb. 13 and Feb. 21, 53 failed. Rates ranged from 3.30 percent to 7.19 percent, and the variable rate is 65 percent of one-month Libor, or about 2.03 percent today.
Auction-rate bonds have become less appealing as confidence in the insurers backing the securities wanes. Even fixed-rate bonds are declining amid the unprecedented failures, and long- term tax-exempt borrowing costs have risen 11 days in a row.
Switching Out
Houston, New York state and other borrowers are considering options including converting their auction-rate bonds to less expensive variable-rate debt. Laura Anglin, New York's budget director, said state officials and advisers are studying how to shift the swaps and avoid paying fees to end the agreements.
A December report released by New York's budget division showed the state would have to pay banks about $156.7 million to cancel swaps requiring a fixed rate. A month earlier, it would have cost $31.3 million.
To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net .
Last Updated: February 28, 2008 00:19 EST
