municipalities face double whammy

Still reeling from soaring funding costs and a shrinking revenue base, some municipal governments are facing loss in their swap deals. Over the past month, public-sector issuers in the U.S., from health care to utilities, have endured a painful spike in their borrowing costs in the $500 billion market for variable-rate demand obligations, or VRDOs. The market allows long-dated tax-free municipal debt to behave like short-term paper with slightly more attractive yields, making it more attractive for investors. Now, some issuers are finding that the very contracts they entered to offset these costs, in the derivatives markets and with bond insurers, aren't only failing them but will be near-impossible to exit without taking crushing losses. Jefferson County, Ala., is the first to show the strain, as Standard and Poor's last week cut ratings on its sewer-revenue debt by six notches into junk territory, owing to "significant increased interest rate costs." The county is now underwater in its swaps transactions to the tune of around $360 million, according to S&P. "Those guys are getting royally smoked," said Doug Dachille, chief executive of bond asset manager First Principles. Many municipal borrowers used the interest-rate-swaps market to lower their financial costs even more. They would cover their floating-rate fees on VRDOs cheaply by paying a counterparty a fixed rate in return for a stream of payments, often set around 67% of the benchmark one-month lending rate for banks, known as the London Interbank Offered Rate. This rate hasn't come close to keeping up with the recent spike in VRDO rates. In fact, it has dropped, in line with aggressive Federal Reserve rate cuts. That means these public-sector issuers must pay bondholders much more than they are getting out of the fixed-rate swap. To make matters worse for Jefferson County, its ratings downgrade means it must post more collateral to the banks on the other side of its swaps agreement. According to documents published by Jefferson County detailing its financial straits, the local government entered into 13 swap agreements with Bank of America, Bear Stearns, J.P.Morgan and Lehman Brothers for a notional amount of $5.4 billion. The rapid-fire downgrades by S&P and Moody's Investors Service triggered protective provisions for the banks. Under the agreements, the county's shakier credit rating obliges it to post $184 million in additional collateral by Friday. This is money the county doesn't have. According to Moody's, Jefferson has roughly $193 million in available cash, but it faces higher financing costs on another type of debt instrument, auction-rate securities, which have fallen on hard times. This could be the start of a nasty cycle for state finances already strained by the ailing housing market and threat of recession. It looks like even their funding sources could take chunks out of their budget. And the solution isn't as simple as canceling the swaps contracts. "Your VRDO's bleeding you slowly, but terminating that swap will bleed you quickly," said Jeff Previdi, ratings analyst at Standard & Poor's. Cancellation would mean an immediate upfront loss that would go straight onto the issuers' books and would look particularly ugly next to the shortfalls already being taken into account; among those are possible shrinking revenues as the subprime-mortgage fallout spreads. Exiting the VRDO is no easier and would come with write-downs of its own. Municipal issuers widely use bond insurers as guarantors to further lighten their funding loads. Canceling their contracts with the insurers would force issuers to surrender those upfront fees, too.