Shake-up brewing in municipal bonds

Millions spent on unnecessary insurance, treasurer says

By ZACH FOX - Staff Writer | Saturday, April 12, 2008 5:05 PM PDT ∞

San Diego County has spent more than $57 million over the last five years on a financial instrument that the state treasurer is calling unnecessary.

The money was spent to reduce borrowing costs by securing a better credit rating for bonds issued by municipalities. But Bill Lockyer, California's treasurer, says the municipalities deserved better credit ratings in the first place, meaning millions of dollars in taxpayer funds have been spent meaninglessly.

Lockyer has launched a campaign pushing for a change in how the nation's leading credit rating agencies do business.

"It's not logical, it's not fair and it doesn't make any sense," said Tom Dresslar, spokesman for Lockyer.

The treasurer claims, and some investors agree, that municipalities receive lower credit ratings than corporations of similar risk profiles.

With a lower credit rating comes a higher interest rate to borrow money. To better the credit rating for bonds, notes issued by municipalities to borrow money, cities and school districts have long bought insurance.

For example, a city with an "A" credit rating might be able to issue $100 million in bonds with an interest rate of 4.9 percent. That same city might decide to buy insurance for $1 million to secure the best "AAA" credit rating.

Theoretically, if the city were to default on repaying the bond, the insurance company would cover the debt. That added security gives investors more confidence, lowering the risk along with a better interest rate.

With the better credit rating, the city borrows money for its bonds at a lower interest of 4.5 percent. Over the 15-year life of such a hypothetical bond, the city will save $5 million in borrowing costs, justifying the $1 million insurance premium.

However, those same insurance companies also backed subprime debt. As homeowners default and the subprime debt becomes worthless, the financial community is questioning the viability of the insurance companies.

Lockyer and others are calling into question the validity of this system. The argument goes: Why should a city that rarely defaults need insurance to secure the best rating, when a company with the same record of default already carries that rating?

If municipalities were awarded better credit ratings, they might not need bond insurance.

It is difficult to determine exactly how much money San Diego County cities, school districts and redevelopment agencies spent on bond insurance because the product is often rolled into other services.

At least $57 million has been spent on the insurance by county agencies over the last five years, according to records from the California Debt and Investment Advisory Committee, a division of the state's treasurer office.

That sum represents just 188 of 526 bond issues over the last five years, though most of the issues have bond insurance ---- but the insurance premiums could not be segregated from other fees for analysis, according to Fitch Ratings, one of the major credit rating agencies.

Some investors say that bond insurance typically costs 1 percent of the amount of debt. With about $21 billion in municipal bonds issued by county agencies over the last five years, insurance costs could be as high as $210 million for the county, assuming all bonds carry insurance.

Some are also struck by the idea of conservative municipalities bettering their credit rating by purchasing products from companies that overexposed their balance sheets to some of the shakiest debt available.

"How can you pay these troubled companies a lower interest rate than small cities when they (the cities) haven't defaulted on anything in the last 10 years?" said Tom Lockard, managing director for Stone & Youngberg, a San Francisco financial firm that underwrites municipal bonds.

Elsinore Valley Municipal Water District decided within the last month to forgo bond insurance after seeing the lower interest rate it secured with insurance disappear. Its insurance company, Financial Guaranty Insurance Company, lost its top rating because of exposure to subprime debt.

Then, investors treated the water district's bonds like the plague, causing the bonds to be rated worse than the district's own credit rating.

Extra interest rates cost the water district $700,000 more a month.

Rancho California Water District in Temecula suffered a similar fate with $200 million of its bonds. Its interest payments jumped from $500,000 a month to more than $1.25 million a month.

Those increases in cost do not even account for the premium paid to the insurance company.

And the insurance is having the exact opposite of the intended effect: It is increasing borrowing costs when it should be reducing them.

So Rancho California reissued the bonds, scrapping the insurance policy and replacing it with one from a company in secure standing.

Elsinore Valley is likewise reissuing its bonds. But it has chosen to go without any insurance.

"At this point, if the environment continues to move forward in the same manner, then it doesn't make sense to buy insurance," said Greg Morrison, spokesman for the water district. "There's no reason to put ourselves at risk because of someone else's financial issues."

Though the two districts could not immediately report the amount spent on insurance because it was wrapped in other fees, assuming the costs were 1 percent of debt issued, the agencies spent $3 million on insurance.

With billions of dollars of state debt issued each year, insurance premiums can add up to a substantial sum.

Assuming a stable insurance company, the state agency saves money over the long run with a better credit rating.

"That's buying something that we should by all rights already have," said Dresslar, the treasurer spokesman.

At issue is how the three major credit rating agencies ---- Moody's, Standard & Poor's and Fitch ---- rate municipalities. Lockyer, the state treasurer, says that if a municipality's financials were applied to a corporation, it would receive a much better credit rating only because it is a business and not a state entity.

Standard & Poor's says it applies the same credit rating to both and has not considered re-evaluating how it rates municipalities.

"We have one rating scale, so we're sticking to that," said Paul Dyson, associate director of ratings for the agency. "And we're open to hearing what the treasurer has to say."

Lockyer's office has applauded Moody's and Fitch for having constructive dialogue about taking a look at how they rate municipalities. But it denies Standard & Poor's uses a singular rating system.

"They keep saying that every chance they get," Dresslar said. "I guess their theory is, if they keep repeating the falsehood enough, people will believe it and it will turn into the truth. It is not the truth."

Some agencies have already turned to upgrading municipalities. Two months ago, Standard & Poor's raised SANDAG's credit rating to the highest possible.

Because most local municipalities already carry relatively strong credit ratings, a similar upgrade could mean many cities and school districts will be able to borrow money at low rates ---- without insurance.

"Going forward, it's not an automatic," said Donald Steuer, chief financial officer for the county, "but I am being faced with the possibility of the first time since I've been here that we'd go without bond insurance."

Contact staff writer Zach Fox at (760) 740-5412 or zfox@nctimes.com.