Auction Rate Issuers Pay to End Swaps

May 9 (Bloomberg) -- Taxpayers from Massachusetts toCalifornia are paying Wall Street banks to end derivativecontracts gone bad as they exit the collapsing auction-rate bondmarket, with penalties in some cases topping $10 million andcompounding the pain of rising borrowing costs. Sacramento County, California, paid Morgan Stanley $5million to cancel an interest-rate swap agreement when itrefinanced $79.5 million in auction-rate securities last month.The fee added to the cost of the bonds after the rate on thesecurities more than doubled to 9.8 percent in March as dealersstopped supporting the market. The breakdown of the $166 billion market where municipalrates are typically set through bidding run by a dealer issqueezing borrowers already hurt by the first decline in statesales-tax revenue in six years, according to the Nelson A.Rockefeller Institute of Government in Albany, New York. Citigroup, based in New York, was the top underwriter ofauction-rate securities in the municipal market, arranging $55billion in sales between 2000 and the end of last year, accordingto data compiled by Thomson Reuters. Zurich-based UBS AG, which said May 6 it will close or sell its municipal bond department,underwrote $42 billion, followed by Morgan Stanley of New York at$22 billion and 19 others. ``Most swaps are negotiated with the investment bank thatdoes the underwriting,'' Fuller said. ``It's unusual that anissuer would use a counterparty other than the underwritinginvestment bank.'' Dealers Flee For almost two decades, auction-rate bonds allowed localgovernments, hospitals, and closed-end mutual funds to issue debtmaturing in as long as 40 years at short-term rates that resetevery 7, 28 or 35 days through bidding. Investors and dealers began to abandon the market inFebruary on concern that the creditworthiness of companiesinsuring the bonds was deteriorating because of their losses fromguaranteeing debt backed by subprime mortgages. More than two-thirds of auctions failed, data compiled byBloomberg show, and the average rate on seven-day securities roseto 6.89 percent on Feb. 20 from 3.63 percent a month earlier, according to the Securities Industry and Financial MarketsAssociation. When an auction fails because sellers' ordersoverwhelm demand from bidders, rates are set at a predetermined``penalty'' level. Municipal issuers have replaced or announced plans torefinance more than $63 billion of auction-rate debt, accordingto Bloomberg data. Redding, California, expects to pay Citigroup $6.7 millionto close out a swap on $67.3 million of auction-rate bonds itsold, said Tom Graves, financial manager of the city's electricsystem, the recipient of the proceeds. Most borrowers also entered into swaps where they agreed tomake a fixed payment in exchange for variable payments from thebanks arranging the transaction, according to Jeff Pearsall, amanaging director at Philadelphia-based Public FinancialManagement, the largest adviser to U.S. municipalities. A swap is a type of derivative, or financial instrumentderived from stocks, bonds, loans, currencies or commodities, orlinked to specific events like changes in interest rates or theweather. In a swap, parties exchange payments based on aspecified amount of debt. For issuers of auction-rate bonds, the variable rates they received, based on the London interbank offered rate, roughly matched the cost of auction-rate bonds for more than five years. The relationship broke down this year as rates on auction-ratebonds soared and Libor fell. Sacramento County did a swap with Morgan Stanley inconjunction with a sale of $79.5 million in auction-ratesecurities for its airport in May 2006. The contract was to lastuntil the bonds, which were insured by New York-based XL CapitalAssurance Inc., matured in 2024. The county agreed to pay the bank a fixed rate of 3.785percent in return for a variable payment that was supposed tocover the cost of the bonds. The rate it received from MorganStanley was capped at 65 percent of the one-month Libor, whichaveraged 5.08 percent that month.