The global spiderweb of debt
If you are not familiar with the municipal bond market, you may think that muniland is nothing more than states, municipalities and school districts offering plain bonds that mature on a set date and offer a fixed interest rate. That is the textbook description.
Actually the municipal bond market is a murky tangle of odd bond structures, variable-rate debt, multiple layers of issuers and bank guarantors. The lack of standardization of bond structures and relationships is one of the main reasons that the asset class has never migrated to the internet for retail investors.
Often the odd bond structures can create much more exposure to the tides of global affairs than plain vanilla bonds. The biggest example now is the Belgian-French bank Dexia, which is a big guarantor of U.S. muni bonds.The WSJ reported in an excellent article that investors are selling off muni bonds that Dexia insures:
From a skating rink in Everett, Wash., to New York City’s schools to Chicago’s O’Hare International Airport, interest rates on some bonds have soared since late May and could rise even further because money-market investors are less willing to buy some of the $17 billion in municipal bond deals backed by Dexia SA, a Belgian-French bank shaken by its exposure to government debts in Greece.
The problem with Dexia’s role here is that many U.S. municipalities issued debt for long-term capital projects (think school buildings, sports arenas, bridges) and agreed to borrowing terms that are reset on a weekly or daily basis. Imagine a super-charged “adjustable rate” mortgage that is constantly moving around depending on interest rates. The adjustable daily/weekly rates are short-term rates. So the issuer has the benefit of funding long-term projects with very low short-term rates. It works really well — until it doesn’t.
Dexia’s fate looks increasing imperiled and muni issuers who use the bank to guarantee their bonds are approaching the problem from different directions. Herald.net of Everett, Washington, reported that their town is taking the wait-and-see approach:
The Everett Public Facilities District, which owns Comcast Arena, issued $27.4 million in revenue bonds now affected by the crisis.
The publicly owned district’s variable interest payments have more than doubled since May — from $14,646 to $39,432 a month.
While the city of Everett doesn’t own the arena, it does guarantee the bonds that paid for its construction. That means if the district couldn’t pay on its debt for some reason, the city would have to pick up the bill.
[Karen Clements, the chief financial officer] deals with bonds as part of her job with the Port. In her experience at the Port, it takes about 60 days to refinance bonds into a fixed rate, she said.
The public facilities district is having no problem making interest payments right now, said Debra Bryant, Everett’s chief financial officer.
Some other issuers are taking advantage of low current interest rates to refinance short-term, variable debt into long-term, fixed rate debt. The state of Georgia issued refunding bonds at 5% interest rate last week to “retire” their Dexia-guaranteed bonds.
This is a very sound move because this not the first time Dexia has encountered problems. Bloomberg’s Bob Ivry wrote an excellent explanation of how Dexia borrowed more from the Federal Reserve in the financial crisis than any other institution. They were borrowing an average of $12.3 billion in daily loans during the 18 months after Lehman Brothers collapsed in September 2008.
The Federal Reserve has never said that they wanted to support muniland through the back door by propping up Dexia. In fact, the Federal Reserve loaned funds to all foreign banks who came to the discount window.
What is not understood by many outside of the bond markets is that most financial institutions are deeply interconnected; they lend directly to other financial institutions, serve as counterparties on credit-default swaps and occasionally guarantee each others’ debts.
What happens to muniland if Dexia collapses from it’s exposure to Greek debt? It’s hard to know exactly, but interest rates for borrowers guaranteed by them will shoot up and finding new sources of liquidity will be hard. The Fed has said that it will not buy muni bonds or lend directly to states or municipal issuers. But be sure if yields rise high enough Merrill Lynch, Goldman Sachs and JP Morgan will be standing ready to “save” these issuers. There is no “lender of last resort” for muniland.