Los Angeles Water Users Escape Swap Thanks to Twist: Muni Credit
The agency that supplies drinking water to almost 19 million Los Angeles-area residents paid $47.2 million to unwind interest-rate swaps with banks. Unlike many municipal issuers, ratepayers didn’t come away with a loss.
Thanks to the Federal Reserve’s Operation Twist, the Metropolitan Water District of Southern California got a chance to borrow last month at lower fixed-interest rates than variable, after more than four years of waiting. It sold $320 million of bonds to refinance debt, end some swaps, cut annual payments by $119,000 and generate $1.1 million of present-value savings.
“It’s giving us an opportunity to unwind the swap and to maintain the savings of the swap even after paying the termination fee,” Gary Breaux, the Los Angeles-based authority’s chief financial officer, said by telephone. “Usually you wouldn’t find it economical.”
Since the financial crisis reached the municipal market in 2008, falling interest rates have left municipalities trapped by expensive payments to terminate interest-rate swaps tied to debt with rates that reset periodically. The derivative deals prevented cities and towns from refinancing debt at the lowest borrowing costs in a generation.
Issuers including California’s water resources department, North Carolina and Reading, Pennsylvania, have handed more than $4 billion to Wall Street banks to end the agreements, data compiled by Bloomberg show. Other municipal borrowers remain stuck with swaps linked to about $50 billion of auction-rate securities, whose rates can change weekly or monthly. Baltimore and Denver have balked at the expense of unwinding such swaps.
For the Los Angeles district, interest rates had fallen so much that it became possible to save money by borrowing to pay the $47.2 million fee to end some swaps. Terminating the deals reduced the risk of unwinding them later at a higher cost. After the transaction, the amount the district would have to pay to end remaining swaps fell to $169.1 million from $225.4 million in May, according to its swap reports.
The canceled contracts were with Citigroup Inc., JPMorgan Chase & Co., Morgan Stanley and Deutsche Bank AG. The agency still has some swaps with all four. Lauren Onis, a Morgan Stanley spokeswoman, Deutsche Bank’s Amanda Williams, JPMorgan’s Elizabeth Seymour, and Scott Helfman, a Citigroup spokesman, all declined to comment.
“Once you have a transaction that puts a swap in place, you have to have another to get out,” said Robert Brooks, a professor of finance at the University of Alabama in Tuscaloosa, who studies derivatives. “And they will charge you plenty of money to get out of it.”
In Operation Twist, the Fed is swapping short-term Treasuries it holds for securities with longer maturities to tamp down long-term borrowing costs.
As 10-year-Treasury yields touched a record below 1.4 percent yesterday, muni interest rates sank as well. Yields on top-rated munis due in 2022 fell to 1.72 percent, the lowest since a Bloomberg Valuation index began in January 2009. The falling yields on fixed-rate, long-term bonds opened an economical way for borrowers, including the water agency, an Illinois school district and the city of Los Angeles, to terminate swap agreements.
“That was unusual because you could take out some portion of the swaps where you couldn’t before,” said Brian Thomas, a former chief financial officer for the water district who is now a managing director in Los Angeles with PFM Group, a municipal consulting firm. “Because of large termination payments, it doesn’t always work.”
Interest-rate swaps, typically used to hedge the risk of rising borrowing costs, are agreements to exchange payments between two parties, such as a municipality and a bank. The deals were set up to reduce expenses by swapping a variable rate for a steady one that was lower than prevailing fixed rates.
For most muni issuers holding such contracts, the termination fees rose as market interest rates fell because the lower yields swelled the contracts’ value from the counterparties’ perspective.
As the Fed’s strategy depressed long-term interest rates, the cost of fixed-rate munis fell below floating rates, lowering the district’s cost of unwinding some of its deals. The water agency’s swaps were tied to some $4.5 billion of bonds sold since 2001, with different yields for each. The authority has about $1.06 billion of swaps left, down about $300 million from before the terminations, according to a July 9 swaps report.
To determine the feasibility of unwinding the deals, Breaux and his advisers looked at two curves -- one representing the cost of borrowing with the swap in place and one for top-grade muni yields. Since early 2011, the swap curve has sporadically exceeded the AAA yield, creating opportunities to refinance some bonds and end some swaps at a lower cost.
“The wider the difference between the two curves, the better,” Breaux said. “The extremely low-rate environment makes it less costly to finance the swap-termination payments.”
The $47.2 million cancellation price let the district end two swaps and parts of five others while maintaining the savings that the agreements were designed to provide, even after covering the costs. As of June 30, the agency said it had saved $85.2 million by using the hedges to lower borrowing costs.
Paying to get out of the swaps also eliminates the risk that future events may force a termination under circumstances the district can’t control, such as a credit-rating downgrade of a bank that provides liquidity to buy back bonds investors no longer want to hold.
The agency’s average interest cost on the new debt was 1.15 percent. After adding in all the financing costs, including the termination fee, the district’s effective interest rate was 4.84 percent -- lower than the 4.92 percent with the swaps in place, which also included remarketing fees and letter-of-credit costs. The agency’s refinancing cost almost $2 million in payments to banks and others that provided services on the deal.
“The swap-termination fees are effectively being paid with what could have been higher present-value savings from the refunding, were it not for the negative mark-to-market value of the swaps,” Moody’s Investors Service said in a June report.
“There are opportunities to terminate and convert, but it doesn’t apply across the board,” Shapiro said. “It applies to issuers that can sell at a good spread to AAA. It all depends on how someone is positioned relative to AAA in the intermediate part of the curve.”
DuPage County Community High School District No. 108 in Roselle, Illinois, sold $9.1 million in bonds in November and $27.6 million in March to refinance debt and unwind swaps. The district told New York-based S&P that the cost of borrowing to end the hedge “is lower than that of keeping the variable-rate debt, liquidity facility and the swap in place,” S&P reported.
The district had a loss, Robert Lewis, a managing director with PMA Securities Inc. in Naperville, Illinois, and the school system’s adviser, said by telephone. The loss stemmed from an interest penalty of at least half a percentage point because the issuer is based in Illinois, the U.S. state with the least- funded pension system, the lowest bond rating from Moody’s and as much as $8 billion in unpaid bills.
“Because we’re an Illinois issuer, we get punitive rates due to the state’s situation,” Lewis said. “They were able to get out of it in relatively good shape.”
The deal was worth doing because it took away the risk of the hedge being terminated unpredictably.
“We wanted to get out of it under our terms,” he said.
Following are pending sales:
NEW ORLEANS plans to sell $160 million of general- obligation refunding bonds as soon as today, data compiled by Bloomberg show. (Added July 24.)
REGENTS OF THE UNIVERSITY OF CALIFORNIA plan to sell $900 million of revenue bonds, including $100 million of taxable debt, as soon as July 26, according to data compiled by Bloomberg. Proceeds will help finance student housing and parking and refinance debt, according to bond documents. Moody’s rates the bonds Aa2, its third-highest grade. (Updated July 24)
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