Sarah Bush Lincoln Health Center was set to borrow about $45 million for emergency-room and laboratory improvements in Mattoon, Illinois, when demand for tax-exempt debt began to dissolve late last year.
Investors, spooked by bank analyst Meredith Whitney’s prediction of “hundreds of billions of dollars” of municipal defaults in 2011, started fleeing the market in record numbers, sending interest rates soaring, according to Craig Sheagren, the hospital’s chief financial officer. As bond buyers ran, JPMorgan Chase & Co. and other underwriters stepped up with offers of loans, letting the institution bypass the public markets.
“I have not seen a better deal yet than what we got,” Sheagren said recently of the 3.6 percent annual cost, almost half the market rate, that the hospital received on 15-year debt in March from JPMorgan in New York. At about the same time, Jamie Dimon, the bank’s chief executive officer, was publicly cautioning investors on the risks of municipal debt.
Refuting Whitney’s forecast, which helped send borrowing costs to two-year highs in January, the $3.7 trillion municipal-bond market rebounded this year, generating an average total return of 10 percent through Dec. 12, better than U.S. Treasuries and corporate bonds, Bank of America Merrill Lynch indexes show. Munis also trounced equities as the Standard & Poor’s 500 Index lost 0.6 percent in the same period.
Jefferson County Bankruptcy
Even after Alabama’s Jefferson County became the biggest government bankruptcy in the nation’s history and some defaults surged, the annual average 10-year borrowing cost for top-rated states and local governments dropped to 2.37 percent Dec. 12 and remained there yesterday, according to a Municipal Market Advisors index. That was the lowest rate since the company began collecting the data in 2001.
The Federal Reserve helped fuel the bond-market rally by buying Treasuries. Banks that were flush with cash from record deposits added to surging tax-exempt returns. While reluctant to lend to companies and consumers amid the weakest economic recovery since early 2007, the institutions increased investments in municipal securities by 20 percent to $272.8 billion in the 12 months through September even as mutual funds and insurers cut holdings, the most recent Fed data show.
“The bank portfolios are dominating the marketplace,” said Tom Doe, CEO of Municipal Market Advisors, an independent researcher in Concord, Massachusetts. “They are taking the bonds you want and establishing the levels at which you buy.”
Diverting Debt Supply
Wall Street also bolstered the market because private placements and municipal loans diverted billions of dollars of supply, according to Bill Montrone, S&P’s head of public-finance ratings. New bond offerings plunged this year, with about $248.5 billion of public sales through Dec. 9, down 37 percent from almost $394.7 billion in a similar period last year, according to data compiled by Bloomberg.
JPMorgan, the largest U.S. bank by assets, was among the biggest municipal lenders, according to data compiled by Bloomberg News. Yet Dimon, 55, publicly urged would-be buyers of state and local debt to use extra care in the months after Whitney made her default comments on CBS Corp.’s Dec. 19 “60 Minutes” broadcast. In March, Dimon said he anticipated 100 municipal bankruptcies.
“You’re going to see some municipalities not make it,” the banker said March 30 in Washington at a U.S. Chamber of Commerce event, echoing comments he made in January, when he noted that there are 14,000 U.S. municipalities. “I don’t think it’s going to shatter America, I just think it’s a part of the credit cycle.”
Jennifer Zuccarelli, a spokeswoman for Dimon at the bank, declined to comment.
By the end of March, tax-exempt interest rates had reversed a surge that began in the previous September, just before Whitney’s eponymous firm issued a report on the market. By Dec. 12, the yield on the 10-year Municipal Market Advisors index of top-rated debt fell 113 basis points, or 32 percent, from this year’s high of 3.5 percent on Jan. 18. A basis point is 0.01 percentage point. Yields decline when bond prices rise.
The rally rolled through the second half even as the pace of municipal defaults quickened, highlighted by the bankruptcies of Central Falls, Rhode Island, and Alabama’s most-populous county, which was weighed down by the sale of about $3.3 billion in sewer bonds led by JPMorgan. The corrupt deals led to guilty pleas or convictions of 21 people by this year.
Pace of Defaults
Richard Lehmann, the Miami Lakes, Florida-based publisher of the Distressed Debt Securities Newsletter, has predicted a record of at least $20 billion in municipal defaults this year, including some that don’t involve missed payments so aren’t counted as such by other analysts, according to Matt Fabian, a Municipal Market Advisors managing director. Fabian says by his count, defaults have reached $2.1 billion this year, down from about $2.8 billion in 2010. Even by Lehmann’s count, the pace falls far short of Whitney’s outlook.
As the year progressed, banks consummated at least $4 billion of direct purchases and private placements, identified through credit-rating reports. JPMorgan handled $500 million of those agreements, while $1 billion went to Wells Fargo & Co. in San Francisco, the third-largest underwriter among U.S. banks, by number of deals. The private deals typically aren’t disclosed by borrowers until annual reports are released months later and when they are, the lender often isn’t identified.
Bank of America Corp. and three other banks bought $376 million of debt directly from Missouri’s Mercy Health system last month while in July the California Academy of Sciences in San Francisco privately placed $257 million. Both deals were confirmed by the nonprofit organizations. New York City has completed $350 million of the sales this year to banks including JPMorgan and Wells Fargo, according to Ray Orlando, a spokesman for the city’s Management and Budget Office.
Replacing Variable Rate
The surge in lending and direct purchases is largely linked to a decline in conventional variable-rate municipal bonds, according to Adam Joseph, a managing director in public-finance capital strategies at Wells Fargo in New York. Before the credit crisis, as much as 20 percent of municipal debt was sold each year with a rate that changed weekly or monthly. Investors such as money-market funds preferred that banks acted as buyers of last resort for much of this type of security, to limit their risk.
Even before Bear Stearns & Co. collapsed and was bought by JPMorgan in March 2008, banks found themselves being forced to step in and buy the securities. As the financial system began stabilizing in 2009, some municipal underwriters opted to keep making direct loans instead of offering to serve as backup buyers for publicly marketed debt.
Owning the Asset
“We’d just rather lend out the $100 million and own the asset and that’s it, as opposed to writing a contingent-liability contract that could force us to buy the asset back at an inopportune moment,” said Joseph. “It’s a very good place to put our money especially in the context of our relationships with the borrowers.”
About half of Wells Fargo’s direct purchases have covered new capital projects while the rest have been used to refinance variable-rate debt, Joseph said. Regulations have reinforced the decision because banks have to keep more capital in reserve when they back variable-rate securities, he said.
For Sheagren, the CFO of the hospital in Mattoon, the financing with JPMorgan marked the first time he had used a so-called private placement to raise funds instead of a public bond sale in his 37 years in the industry. “It was a win-win for everybody.”
“All you hear from the national press is the banks are not lending,” said David Johnson, a managing director in the health-care and higher-education group at BMO Capital Markets in Chicago. “What we’re seeing is that the banks have all of these deposits and they have to do something. And they are doing direct placements.”
Credit-grading firms and regulators remain skeptical. Both S&P and Fitch Ratings have said borrowers were taking too long to disclose such loans, leaving investors with an incomplete picture of their debt. The Municipal Securities Rulemaking Board, which governs the market, last month said it had taken up the matter with the U.S. Securities and Exchange Commission.
The raters and regulators also have warned that terms of direct placements may favor banks, such as by letting them force borrowers to accelerate repayment when credit marks are cut.
“This is very different from long-term fixed-rate debt,” said Andy Majka, managing director and chief operating officer at Kaufman, Hall & Associates in Skokie, Illinois, which advises hospitals. “The bank can pull this relationship. They have some pretty important protections.”