By Nicholas Contompasis
Just when we thought local governments finally got the message that overspending was not a good idea for their entities, they get a knock at the door from the devil, big banks. Now, these babes in the woods that run cities and counties will be borrowing their deficits rather than cutting costs and waste.
Unfortunately, this idea is starting to sound like another way of kicking the can down the road. This rewarding of bad behavior is going to lead to more problems in the future for them.
The banks are looking everywhere to make money these days since the economy has pretty much dried up the entire country.
As these governments become more indebted to banks and the Fed so goes their autonomy and their citizenry.
In Shift, Municipalities Turn to Banks for Loans
By MICHAEL CORKERY
Time was running out for the Orange County School Board. A $105 million debt deal was about to expire, triggering painful penalties for the approximately 175,000-student district in the Orlando, Fla.-region.
Along came Wells Fargo & Co. with a deal that avoided the penalties: Wells bought the $105 million debt from investors and negotiated new terms with the district.
"We got a good deal,'' says Richard Collins, the district's chief financial officer.
Such deals are cropping up in many cities and states across the U.S. Teams of bankers are blanketing the country pitching transactions like the one in Orange County, as well as traditional loans, to government officials, people in the industry say.
While big banks still are tight-fisted with many homeowners and small businesses, they see cities, states and schools as one of their least-risky ways to put to work some of the piles of cash that have amassed on their balance sheets.
But the encroachment into territory long dominated by municipal-bond investors is sparking concern that the deals may have downsides for municipalities—and their bondholders. Among them: that bondholders might not be made aware of all of the terms of the deals, which are privately negotiated between the banks and the municipalities.
Federal Reserve data show commercial banks boosted their municipal holdings—both loans extended and municipal bonds scooped up—in the first quarter by a seasonally adjusted annual rate of $18.5 billion. That is a reversal from the first quarter of 2010, when banks decreased their municipal holdings by a rate of $1.2 billion.
"We want to grow our balance sheet, and these are good quality assets,'' says Phil Smith, head of Wells Fargo's government-finance group. While declining to provide specifics, he said the bank has completed billions of dollars of municipal deals this year, aiming to double last year's volume.
The state of New Jersey, which earlier this month finalized a credit line of as much as $2.25 billion from J.P. Morgan to cover a cash shortage until it can prepare a traditional bond offering, has fielded multiple offers for bank loans for other funding needs, according to people familiar with the matter. The state has no immediate plans to pursue the proposed loan deals, these people say.
Bankers have pitched the idea that such loans require less documentation than a public bond offering, because a loan is held by banks or sold privately to institutional investors, these people say. But that means bond investors accustomed to learning much of what they need to know from publicly filed bond documents may have to go digging to stay on top of developments.
Barring extra monitoring, "an issuer could have a sizable increase in their debt, and I might not know that until their next audit or public borrowing,'' says Richard Ciccarone, chief researcher for McDonnell Investment Management near Chicago, which manages about $7 billion in municipal bonds.
Another bondholder worry: The deals can raise issues about the pecking order for repayment, should a borrower become financially stressed.
"The question for us is whether a loan becomes a senior lien to other outstanding debt,'' says Peter Hayes, portfolio manager of Blackrock Inc.'s $102 billion in municipal bonds. "In some cases, there is certainly that potential."
The transactions also can have provisions tough on the borrowers. Oaklawn Hospital, in Marshall, Mich., owes $10.6 million in loans and $67.4 million in bonds held by a total of three banks. It is required to keep 75-days worth of cash on hand to fund operations. Such a demand is not routinely used in municipal finance, according to Jeffrey Previdi, a municipal analyst at Standard & Poor's.
"We have 150 days cash on hand so it is not an issue for us,'' said the hospital's CEO, Rob Covert.
If the cash level dips at the 94-bed hospital below the required amount, the banks can demand accelerated debt repayment, according to a June report by S&P, explaining the rationale for changing its outlook on the hospital to "negative" from "stable."
Still, many banks and borrowers see the deals as mutually beneficial.
Banks get tax breaks for lending to municipalities; they can deduct certain lending expenses, such as carrying costs, and they earn tax-free income up to specified levels on municipal bonds they hold. They also are motivated to lend to municipalities because letters of credit and other guarantees, previously popular lines of business with cities and states, are subject to stricter capital requirements than they used to be.
Direct lending solved a problem facing the Orange County school board, one of the nation's largest school systems, in April: It had $105 million in variable-rate bonds with an expiring bank guarantee. That guarantee was a must to the investors holding the debt.
Further complicating the matter: The district had entered into a financial swap to offset some of the interest-rate risk of the bonds. If the district refinanced, it would have to pay $15 million to unwind the swap.
That sum of money pays the salaries of more than 250 teachers, says Mr. Collins, the finance chief.
It offered to buy the $105 million in debt, keeping the swap in place, and the terms were better than those of rival bidders, Mr. Collins says.
But some terms are of concern to S&P. For instance, Wells could declare "an event of default" if there was an "adverse material effect," or change, in the school board's finances, operations or prospects, S&P wrote in a report this spring.
An event of default could force the district to pay back the debt, which matures in 2032, in six-month installments over five years, with a final balloon payment, S&P noted.
A Wells spokesman said the transaction doesn't expose the school district to any more risk of accelerated repayment than do bond deals involving letters of credit.
"A material adverse change could mean different things to different people,'' says S&P's Mr. Previdi. "Other bondholders could be in the dark about what constitutes a 'material' event."
Mr. Collins says district officials, in negotiations with the bank, had balked at the "material adverse" clause, to no avail. In the end, he says, the school's financial adviser and bond counsel "reviewed all the documents and determined that the district's best interests were protected." If debt repayment ultimately is accelerated, the district believes it would have the ability to refinance into longer-term debt, he says, adding that the district alerted ratings firms to the transaction's details.