The Great Recession was caused in part by overextended homebuyers who took out loans to purchase homes that cost more than they could afford. They were enticed by banks offering low or no down payments, coupled with interest rates that were low at first but could rocket up later. The housing market collapsed when those interest rates were ratcheted up, and homeowners could no longer afford their mortgage payments. Some were able to refinance, but many others walked away.

A similar problem faces states, cities, counties, other types of local governments and other public borrowers that have tapped into the municipal bond market to fund projects and other spending using variable interest rates and a guarantee by a third-party “liquidity enhancer,” usually banks. In Illinois, officials have no idea of the scope of the problem, although state government itself is not currently ensnared in any variable interest rate borrowing. The problem seems to be limited to local governments and so-called conduit borrowers — public entities, such as local hospitals, that borrow money using municipal bonds because of the tax-exempt status of the interest earned by lenders. 

Meanwhile, state government hopes that its financial troubles, which continue despite a 67 percent income tax increase passed in January, will not include difficulty borrowing on the municipal bond market, particularly if the legislature eventually approves some sort of borrowing plan. The state is expected to have $8 billion in unpaid obligations at the end of Fiscal Year 2011, according to Illinois Comptroller Judy Baar Topinka.

Typically, when a local government sells bonds for a project, a new bridge for example, it borrows the money at fixed interest rates for a long period, often 20 to 30 years. Sometimes, the bonds are paid off with a set revenue source. In the bridge example, motorists pay tolls when they cross. Other times, cities can sell general obligation bonds backed by everyday tax revenues, such as property or sales taxes.

In the mid-2000s, before the 2008 crash, a significant number of local governments and conduit issuers sold long-term bonds that were repriced weekly, says John Sinsheimer, director of capital markets for the state of Illinois. 

“You could call it a bit of alchemy,” Sinsheimer says, “because instead of paying for 20-year money at a 20-year rate, they paid for 20-year at a one-week rate. In order to do that, the bondholders wanted to know: ‘Well, if I’m going to buy this paper, I’m not interested in getting a one-week rate for 20 years. I want to know I can sell it at any time.’ So the papers that were done like this — the bonds — were always backed by a series of legal commitments from third parties. … Normally, these were called liquidity enhancements.”

In a liquidity enhancement, a bank would provide letters of credit that guaranteed the deals in exchange for a fee. But now, the banks that provided the liquidity enhancements have lost their bond ratings or aren’t capable of offering the kind of credit support they did during the last decade, Sinsheimer says. Most of the deals were for between five and seven years.

“In other words, it’s a 20-year bond, but the liquidity enhancer said, ‘I’ll be here for five years,’” Sinsheimer says. 

Such deals are a small chunk of the $3 trillion municipal bond market. An estimated $80 million to $100 million in variable rate, short-term notes are out there that need to be refinanced from bank-loan agreements, says Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management in Oak Brook.

Sinsheimer describes the problem as potentially significant. For instance, nearly $125 million in variable-rate bonds used to finance part of the Reliant Stadium in Houston, Texas, are due in 2014 instead of 2030, according to the Houston Chronicle.

“Depending on the agreement with the liquidity enhancer, many of these deals came with what’s called a term-out. If you don’t replace the liquidity enhancer, the bonds automatically start to repay faster than you otherwise would have expected them to,” Sinsheimer says. 

“The best example I could give you for purposes of trying to make this understandable,” he continued, “would be that if you took out a 30-year mortgage on your house and you got a floating rate on it. Your local bank agreed that if, for whatever reason, the holder of the paper wanted to sell it, they could, and now your local bank is no longer there, and you’re forced to refinance your mortgage at today’s rates, which may be higher than what you could have done when you bought the house five years ago.” 

The severity of the problem in Illinois is unclear, but the solution is obvious, while also potentially expensive. Few banks are willing to enter into these types of arrangements, and for those that do, the charge has skyrocketed. Some banks used to provide such backing for as little of 0.001 percent of the total amount of money to be raised by the bonds. Now, the price is as much as 1.25 percent, Sinsheimer says. 

“The solution for either the municipal or the conduit issuer is to refinance the paper at a fixed rate. Rates may be higher today than they were. It may cost them more. If they can get a liquidity enhancement put in place, it may cost them a lot more than what they did before,” Sinsheimer says. 

“Yes, there is an issue. The market is aware of it. The bankers are aware of it, and the result will be that many of the issuers will be forced to do something. You could see some municipalities —and this is nationwide, this is not just Illinois — you could see some issuers get into financial stress.”

Ciccarone believes one major seller of such bonds is the city of Chicago. City finance officials did not return telephone calls seeking comment for this article.

“I don’t know whether it’s this year or not, but they do have that paper outstanding. I know the city has had a lot of variable rates outstanding,” Ciccarone says.

Problems with such financing probably will not be evident until they blow up, Ciccarone says.

“The concern about the refinancing risk seems to have cooled, but it is still there,” Ciccarone says. “We’re always waiting to see if there’s something behind the scenes. The problem is a lot of these renegotiations … are not very public. And so the market doesn’t have a lot of advance information on if they’re going badly. 

“To date, most of these refinancings have been getting done nationally. And I know of no reason to believe, even in Illinois, they’re not getting done.”

It will be up to individual public borrowers and their governing boards to determine the scope of the problem, Sinsheimer says. The state is not monitoring the situation.

“We’d have to look at every bond that was issued by all of them —— remember, these bonds could be issued by everything from your water reclamation to your school districts to your local municipalities — we’d have to look at every bond that was issued and try and analyze whether or not they were floaters, fixed, did they have a liquidity enhancer, when did that expire?” Sinsheimer says. “It’s something that needs to be done at the local level. … There are no two bonds that would be the same.”

Illinois state government does not have any variable-rate bonds backed by bank notes, but it may again seek access to the municipal bond market this summer if the legislature approves billions in borrowing that Gov. Pat Quinn and legislative Democrats want to catch up on payments the state owes service providers and local governments. Quinn proposed borrowing nearly $9 billion in his state-of-the-state address earlier this year.

Approval of such borrowing will necessitate the agreement of at least a few Republicans because a three-fifths majority is required in each legislative chamber. As of mid-May, Republicans have balked at what Quinn has pitched as refinancing money the state already owes. 

There are differing opinions as to what attitude bond buyers will have toward the state’s seeking again to borrow money to pay what were essentially day-to-day operating expenses. 

Sinsheimer points to the successful deal in February to sell $3.7 billion in bonds to make the state’s Fiscal Year 2011 pension payment. The income-tax increase smoothed the waters for that deal and will probably be a positive factor if the state goes to the markets again, he says. The state had $6.2 billion worth of bids for the $3.7 billion in bonds, which helped push down the interest rate charged to the state to borrow the money. 

Investors who bought those bonds have not traded them at a high rate, and the interest rates in the post-bond sale market have not dramatically changed, Sinsheimer says. In that market, the interest rates on bonds that were set to mature in seven years dropped by about 50 basis points, or one-half of 1 percent. 

“If there’s not a lot of volume, that says the buyers are very comfortable with the credit. They’re very comfortable with the pricing on the bonds, and they want to hold them for a while. And that’s good,” Sinsheimer says. 

“The tax increase has dramatically altered the view of the market on the state’s credit. The tax increase does not permanently fix the problems the state is facing. The tax increase gives us four years of stable fiscal platform, fiscal performance, during which time we now need to go back and change the way we spend our money.”

Another way to measure the health of bonds is the price of insurance to guard against their defaulting — a financial instrument known as a credit-default swap. The cost of a credit-default swap for Illinois bonds has steadily fallen since the tax increase was enacted in January. 

The high point for an Illinois credit-default swap so far this year was 360 basis points on January 6, according to Markit Intraday, a firm that prices such financial instruments. That means it would cost $360,000 to insure $10 million of Illinois debt over 10 years. On April 19, an Illinois credit-default swap was down to 232 basis points. 

“I attribute that to two reasons,” says Otis Casey III, Markit’s director of credit research. “First, the tax increases enacted by Illinois demonstrated significant political resolve to address credit concerns. Overall, municipal credits have tightened since the early part of the year as municipal issuers have balked at paying elevated yields [interest rates] and thus withheld new issuance. That said, investors seem concerned that spreads could widen out again if tested with significant new issuance.”

But the price of credit-default swaps for Illinois is significantly higher than for all other major public borrowers. A credit-default swap for New York City stood at 149 basis points, New Jersey was 157 basis points, Florida was 105 points and Virginia was at 75 points. Even California was at 218 points on April 19. 

The state’s financial condition also has an impact on the ability of local governments to borrow. Decatur City Manager Ryan McCrady says analysts with Moody’s Investors Service were concerned about how much money the state owed the city when Decatur went for an $41.7 million bond issue in October.

“They asked us on our outstanding revenue … how much assurance we had that we would actually collect on those. They want to know how far the state’s behind and those kind of things,” McCrady says. “The money that was owed to the city was for the most part income tax receipts, which are laid out by state statute and have to be paid. So there was a reasonable assurance to Moody’s that we were going to get that money eventually.”

Ciccarone says there is something to be said for a state in as bad financial shape as Illinois still being able to borrow. But he noted that a significant number of those who bought Illinois’ pension bonds were foreign sources, and the costs were significant. About $520 million of the $6.2 billion in bids were from overseas buyers.

“They did get market access. They got it at 200 basis [2 percentage] points higher than the others might have paid. They were 100 [basis points] higher than other states and 200 higher than treasuries,” Ciccarone says. 

“It was helped out by the fact that they went with a taxable bond market issuance. And, therefore, it went to some nontraditional municipal investors, including foreign investors. If they issued that as tax-free alone, I’m not sure how well that would have done. It may not have done as well. … You have market access until you don’t have market access.

“They’re expecting that it will go because they were able to get that deal done a couple months ago. However, it’s not a forecast for clear skies. There’s going to be some turbulence in the air to do that type of financing, even some home-grown turbulence. There’s a question mark as to whether this is prudent management to do another $9 billion of operating expense borrowing to put it out there long term.”

Chris Wetterich covers state government and politics for the Springfield State Journal-Register and GateHouse News Service.

Illinois Issues, June 2011