Trying To Make Sense Of Water Company's Variable Rate Bond Mess

I continue to feel apoplectic towards Indianapolis public officials' complete lack of interest in learning the who, what, when and why of the interest rate swap notes which are contributing to the current financial demise of our Capital Improvement Board and Indianapolis Water Company. Last week, the Indianapolis Waterworks Board voted with little discussion to begin refunding three variable-rate bond issues totalling $448 million that carried a penalty of at least $85 million. The Board also voted to limit to 15% the share of debt issued by the water company that could be comprised of variable-rate bonds in the future. When a board member asked the water company's bond counsel on those original issues, Brenda Horn of Ice Miller, to explain the limitation, Horn said she lacked the qualification to answer his question because she is a bond lawyer and not a financial advisor. The former financial advisor, Umbaugh & Associates, has subsequently been replaced by Crowe Horwath. Without receiving any detailed explanation from a "qualified financial advisor", the Board moved forward with the adoption of the resolution. Despite knowing that the actions of the Board in 2005 to approve variable-rate bonds to replace the original fixed rate bonds approved as part of the original purchase of the water company from NiSource in 2002, had resulted in the interest rates on the debt climbing from the original 5% interest rate charge to more than 9% and a penalty payment of $85 million to get out of those notes, not a single member of the Board asked any questions to understand what had gone wrong.

The fixed rate bonds were replaced in 2005 with what are called interest rate swap notes. An "interest rate swap" is "a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows." Indiana taxpayers first learned that both state and local units of government had opted for these derivative debt instruments in February, 2008 when the IBJ's Peter Schnitzler reported that the state's decision to finance the construction of Lucas Oil Stadium with variable-rate bonds had resulted in significant interest expense for taxpayers. Schnitzler wrote at the time:

The debt strategy Gov. Mitch Daniels’ top financial officials developed to save the state money on major projects like Lucas Oil Stadium has turned sour. To pay for construction, the administration over the last few years issued $810 million in “auction-rate” bonds—a form of variable-interest-rate debt that once promised to shave costs. But this month’s unexpected meltdown of the U.S. auction-rate securities market has opened the state to risk of sudden spikes in interest.

And now, to avoid extraordinary payments for debt service, Indiana may have to spend millions of dollars on fees to issue replacement bonds.

As far as Wall Street credit rating agencies are concerned, the sooner Indiana addresses its problem, the better.

“We’d expect for a state as highly rated as Indiana, in this situation, that they would take some sort of action relatively quickly,” said Nick Samuels, a vice president for New York-based Moody’s Investors Service. “The state certainly understands what this issue is. And my understanding is they’re working on finding a solution.”

Daniels' Budget Director Ryan Kitchell downplayed the negative impact of the variable-interest rate bond problem to Schnitzler at the time. Kitchell told the IBJ the state would simply refinance the debt, and that the state could easily absorb the higher interest rates because of the lower interest rate savings the state had initially realized. The state refunded these riskier bonds last year, presumably, as did the Capital Improvement Board. Refunding variable-rate bonds cost the CIB nearly $17 million last year. To cover the hit, the CIB obtained an emergency loan from the State Treasurer, which it paid back this week nearly two months ahead of its payment due date. Bob Grand told the Municipal Corporations Committee that if the Board hadn't acted when it did, that $17 million would have risen to $40 million today. This begs the question of why the water company's variable-rate bonds were not similarly refunded at the same time to avoid higher interest and pre-payment penalties.

Experts with whom Schnitlzer spoke to suggested the initial decision to issue variable-rate bonds was not wise, including Diana Hamilton, who had served as a finance adviser for Govs. Frank O'Bannon and Joe Kernan. She is married to Ice Miller partner, John R. Hammond, III. Hamilton told Schnitzler at the time:

The Democratic gubernatorial administrations of Frank O’Bannon and Joe Kernan also did not tap that market, said Diana Hamilton, who ran the predecessor to the Indiana Finance Authority for both men.

“Not because I’m so much smarter than everybody else. It was really just a pricing thing,” she said. “These things change in the market a lot, and typically with auction-rate debt, you need to purchase bond insurance. And also the ... fees paid to the investment banker were higher.”

Yes, the bond issuer had to purchase insurance to issue this riskier form of bonded indebtedness. In this case, the bond insurers were MBIA and Depfa Bank. Bear Stearns entered into the swap notes with the Bond Bank. The bond prospectus laid out the risk of higher interest rates for the issuer. "If interest rates are materially higher than forecasted rates, debt service costs to the [water company] could result in lower debt service coverage or insufficient Net Revenues to pay such increased debt service costs." This is what perplexes me, the prospectus indicates that the water company had minimized its risks from higher interest rates with the interest rate swap. The prospectus stated that a hedge agreement "effectively convert[ed] . . . [the water company's] variable rate exposure . . . to a fixed rate." It warned that the water company "may owe a termination payment" due to a "significant ratings reductions by any party" if the hedge agreement was terminated. "Any such termination payment could be substantial and potentially adverse to the [water company's] financial position." It added, "[T]here can be no assurance that the Bond Bank would be able to obtain a replacement hedge agreement with comparable terms."

Did any of the parties on behalf of the Indianapolis Water Company, the Board and the Indianapolis Bond Bank who made the decisions to enter into these interest rate swaps truly understand the risks associated with them at the time they were asked to sign off on them? If today's scenario as being played out had been explained to them, it is inconceivable that these decision-makers could have incurred such extraordinary risk to the taxpayers. They were essentially playing craps at a Las Vegas casino on our dime. In this case, the water company's variable-rate bonds became problematic because the insurer's ratings were downgraded. The Bond Buyer explains this in its recent edition:

The problems with the issues reflect those that have afflicted borrowers with insured floating-rate debt over the last year as insurance downgrades prompted failed remarketings.

Skyrocketing liquidity costs complicated restructurings that leave the debt in a floating-rate mode while negative swap valuations that would lead to costly termination payments dampened the appeal of converting to a fixed rate.

As the cost of the variable-rate debt rose, the water district was unable to maintain required debt service coverage levels, and earlier this year began petitioning Indiana for an emergency rate increase to boost those coverage levels, said officials.

In addition to spending roughly $15 million more than budgeted last year on interest costs, the bond bank was forced to take out a $14 million loan to serve as collateral on a chunk of the debt that failed during a previous remarketing cycle and is now held by the bank liquidity provider. A $22 million payment under an accelerated repayment schedule required under the liquidity contract will be due in July if the debt is not refinanced by then, bond bank officials said.

The bond bank will also have to make a roughly $85 million swap termination payment as it refunds one of the debt series into a fixed-rate mode.

"We're at the point where we can't wait this out," said Deron Kintner, the bond bank's general counsel and deputy director. "We need to act. The water works bonds are priority number one." Fitch Ratings recently downgraded the water utility's outstanding debt to A-plus from AA-minus. Moody's Investors Service on Monday put the A1-rated debt on negative watch. Analysts cited the deteriorated debt service coverage as well as a number of other problems associated with the variable-rate debt, as well as the uncertainty of the pending rate increase. Standard & Poor's rates the debt AA-minus.

The three debt series, which total roughly $488 million, were originally sold in 2002 as part of a larger borrowing that allowed the city to purchase the water utility, which had been run by a private owner for a number of years. At the time, the $600 million deal was the largest borrowing in the city's history.

The bond bank refinanced a swath of the debt in 2005 to achieve savings to use for capital improvement projects.

The Indianapolis Department of Waterworks covers both Indianapolis and nearly all of Marion County, as well as portions of seven surrounding counties. The utility serves about one million customers. Of the district's $843 million of debt, nearly 60% is in the variable-rate mode. If the planned restructurings are successful, the utility's floating-rate exposure will drop to 5%.

The plan calls for refunding a $388 million series and a $48 million series, both VRDOs. Both are currently held by liquidity provider Depfa plc. A third series totals $50 million and is currently in auction-rate mode.

The bond bank plans to enter the market within the next few weeks to refinance the two smaller bond series and return in June to refund the $388 million issue, officials said.

Morgan Stanley is the underwriter and Crowe Horwath LLP is the bond bank's financial adviser. Ice Miller LLP is bond counsel.

The refundings will allow the bank to shed the insurance coverage provided by now-downgraded MBIA Insurance Corp. on all three series.

In refunding the $48 million 2005 VRDOs, the finance team plans to maintain the debt in the variable-rate mode but substitute a letter of credit from Harris NA in place of a standby bond purchase agreement with Depfa. Keeping the debt in the variable-rate mode allows the bond bank to maintain the existing swap with JPMorgan and avoid a termination payment, Kintner said.

The bond bank plans to refund the $50 million of auction-rate debt into fixed-rate mode and drop MBIA. He said no swaps are associated with the debt, and the finance team is still considering whether to purchase new insurance for those bonds.

In June, the bond bank expects to refund the $388 million series into fixed-rate debt, shedding the insurance as well as Depfa as the liquidity provider. The utility will be forced to pay roughly $85 million to terminate a swap on the debt, Kintner said. The swap counterparties are JPMorgan and Loop Financial Products LLC.

"The big piece has caused the most headaches," he said. "The termination value is extremely high, and the market isn't producing the liquidity needed to keep those in variable-rate mode. Our only option appears to be refunding those bonds with fixed-rate bonds and terminating the swap. We would like to avoid the fee but don't see any way around it."

The bond bank hopes to increase the size of the final refunding transaction to include the swap termination payment, but is still talking with its bond counsel to determine whether it would qualify as tax-exempt under the tax code, Kintner said.

The bank estimates it paid around $15 million more than budgeted last year - $57.3 million - on debt service, largely due to downgrades of MBIA and Depfa. The escalating costs led to a decline in debt service coverage to 0.99 times, below the bond-covenant requirement of 1.1 times.

Under the original bond agreement, the city is required to immediately petition the state commission for a rate increase once coverage drops below 1.1 times.

If The Bond Lawyer is too complicated for you, let's try Talking Points Memo's Moe Tkacik, who has an excellent explanation of what is happening to the Indianapolis Water Company right now and picked up on the issue after reading of all blogs, Advance Indiana:

Another day, another group of American taxpayers forced to cough up tens of millions of dollars to Wall Street over a little-noticed provision in a "swap" contract gone sour. Last week we brought you the parallel tales of sudden budgetary meltdown in Tennessee, Alabama, Illinois, New Mexico and Philadelphia that in part prompted the credit rating agency Moody's to issue a blanket negative credit outlook on all bonds issued by American cities and towns. Today it's the Indianapolis Water Authority being screwed in a swap deal that might force the utility -- and by extension, its customers -- to cough up a collateral call of as much as $100 million.

The deal is a familiar one: in 2005 the city of Indianapolis refinanced $550 million in fixed-rate bonds to raise money to fund its acquisition of its old water company from the private utility company NiSource, which agreed to sell it as a condition of regulatory approval of its merger with Columbia Energy Group. The deal involved the ailing bond insurer MBIA as well as a similar German-Irish firm called Depfa Bank, which insure the utility's ability to pay up by writing credit default swaps on municipal bonds that protect investors in the event of default. But as Barney Frank pointed out last week, the risk of municipal bonds defaulting is historically minimal -- while the risk that MBIA and Depfa might default was steadily rising as they began to chase the riskier (AIG-dominated) business of writing swaps on collateralized debt obligations. And when those "insurers" started to see their credit downgraded last year, suddenly it was municipalities like Indianapolis that were swamped with calls demanding collateral -- which translates to a major refinancing being funded by an emergency 17.5% rate hike this summer.

If you're having trouble getting your head around how this works, it's a little like this: in order to get a cheaper interest rate on your mortgage, you pay you bank extra for a "swap" insuring the investors who buy the mortgage in the case of your default. But then the bank that originated the mortgage starts making riskier loans and its credit rating agencies downgrade its debt, it turns out the owner of your mortgage can demand collateral from you. Except in the case of municipal bonds, the homeowners are cities and towns with the legal authority to tax citizens and an infintessimal record of actually defaulting -- and the banks were using your interest payments to extend home loans to unemployed high school dropouts and senile 80-year-olds living on Social Security.

Cities and states got suckered into these deals through a mixture of corruption and incompetence. In Tennessee, it appears to be the former; in Illinois, where former Gov. Rod Blagojevich has been charged with taking a cut of an $809,000 fee Bear Stearns paid a lobbyist for steering it the lead underwriter position in a 2003 swap deal, an elaborate conspiracy of corrupt public officials allegedly enabled such transactions.

No official corruption investigation into the Indianapolis deals has yet been announced, but a blog that has been following the deals depicts a typically cozy clique of bond lawyers, bankers and accountants surrounding the city's Bond Bank. This
paragraph in particular jumped out at us:

And just for the fun of it, it's worth noting that the person Mayor Ballard named as executive director of the Bond Bank is Kevin Taylor, who joined city government after leaving AIG's Global Investment Group. Yes, that's the same AIG of mega-government bailout fame. AIG's entry into the business of bond default insurance contributed to its financial mess. You just can't make up stuff this good.

And while enough newspapers are still in business to bring you the tale of a new city, state, school district or park authority getting screwed every day by the same unregulated swaps that begat the crisis, why would you bother?

Enough said. Will somebody in government please investigate what is going on? You at least owe the taxpayers that much after we're being asked to cough up all of the higher interest costs and penalty payments to the very people who just keep screwing us harder and harder as the days pass.