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Weekly UpdatesStandby Bond Purchase Agreement
SBPAs are facilities that allow for the short-term liquidity rating of the liquidity provider (bank or financial institution) to substitute for the liquidity rating of the issuer and are stronger than lines-of-credit, but still technically "unenhanced" In the case of the SBPA, the liquidity rating will be the lower between the short-term rating corresponding to the bond issue or the liquidity rating of the bank. As a practical matter, most issuers of VRDOs where a SBPA is utilized for liquidity purposes also purchase bond insurance from a monocline bond insurer for the long-term bond rating. If the bond insurer backing the bonds is rated at least 'AA-, and the bank providing the SBPA has a liquidity rating of 'A-1+,' the issue itself receives a liquidity rating of 'A-1+.' When an SBPA is utilized, the credit of the bond insurer typically backs the regularly scheduled principal and interest payments, but it is not responsible for bond tenders or payment accelerations or early redemptions. Unlike the irrevocable liquidity provided by an LOC, liquidity support from an SBPA can be withdrawn under certain circumstances, generally related to the credit quality of the issuer. Most SBPAs include provisions allowing the liquidity support to be immediately withdrawn by the bank if a rating is lowered below 'BBB-.'
Letter of Credit
Issuers can substitute the credit of a bank for their own in a VRDO financing with an LOC, which is typically irrevocable once entered. Such issues are referred to as enhanced VRDOs. Credit enhancements are generally more costly, but can be a viable option for lower rated entities that, after factoring in the expense associated with the LOC, still see a benefit from issuing variable rate debt. In these situations, the long-term and short-term liquidity ratings assigned to the bonds reflect the credit and liquidity strength of the LOC bank, not the issuer. In irrevocable direct pay LOC-backed bond financings, investors look to the bank for regular as well as tender-option payments. In this way, investors are even protected from bankruptcy of the issuer. Other LOC structures (prioritized direct-pay and standby LOC) are less definitive with regard to bankruptcy and preference concerns, but this issue is outside the scope of this article.
Self-liquidity
A liquidity assessment is an evaluation of the sufficiency, credit quality, and liquidity of an issuer's fixed-income assets and cash relative to its potential short-term debt obligations. Liquidity assessments were introduced by Standard & Poor's in 2000 after a number of debt issuers indicated that bank liquidity facilities were often expensive and cumbersome to administer.
In the past seven years, almost 40 municipal issuers across many public finance sectors with a surplus of high-quality, short- to intermediate-term fixed-income assets have sought to use these pools as back-up liquidity support for their short-term debt issues. Issuers using liquidity assessments range from smaller institutions such as the University of Vermont, to government entities like the State of Texas, as well as large private-sector institutions.
The requirements to obtain a Standard & Poor's liquidity assessment, as well as the details of the process are depicted in Exhibit 1.
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In regards to debt coverage requirements, an issuer must ensure on an ongoing basis that its available assets are sufficient, safe, and liquid enough to meet at least 100 percent of maturing CP in an upcoming 0- to 90-day period, depending on the rating level, or the full amount of a potential VRDO tender based on the tenders notice period. The 100 percent requirement provides a minimum of 1.0x coverage of debt by available assets.
The asset management team's ability to liquidate assets timely is a key factor in the evaluation of the issuer's ability to provide its own liquidity support. An issuer must demonstrate its ability to provide cash (i.e., liquidate assets) when needed (i.e., the payment date after the notice period upon the occurrence of a failed remarketing), which has to be consistent with the timing sequence identified in the relevant legal documents. For the issuer to show it can provide cash when needed, one of the liquidity assessment's critical requirements is a comprehensive liquidation letter that details the liquidation procedures.
Liquidity assessments provide finance officers with another important alternative to traditional sources of liquidity support. By having the ability to leverage their internal fixed-income assets and cash, issuers are provided a cost-effective alternative to traditional bank liquidity support, which includes lines of credit, LOCs, and SBPAs. The assets actually play a dual role as they earn interest and at the same time pro vide the liquidity for variable rate debt. In addition, Standard & Poor's affirmation provides a credible and accurate opinion from a third party's perspective with regards to an entity's ability to provide self-liquidity
When an external bank's line of credit is in place, a major concern for any finance officer would be the occurrence of event risk associated with bank rating actions. Event risks are unforeseen market behaviors. This unexpected behavior could possibly hinder a bank's ability to provide timely liquidity for debt obligations, which might cause failures in remarketing and thus might lead to a negative impact on the rating. However, with a liquidity assessment the issuer has more control over its bond and liquidity rating. Because the vast majority of issuers are highly creditworthy, with long-term debt ratings of AA-' or higher, the deterioration of the issuers' liquidity position is less likely
CASE STUDY: THE STATE OF TEXAS TREASURY POOL
The State of Texas Treasury Pool is an example of a public entity that utilized a liquidity assessment to have its assets evaluated and monitored as liquidity support for its variable rate debt, which is comprised of bond offerings issued by various Texas state agencies. The State of Texas Treasury Pool was originally formed in 1989 and, excluding the management of numerous endowment funds, was the only such pool overseen by the Texas Comptroller of Public Accounts, which now also oversees Local Government Investment Pools, lottery funds, and separate accounts belonging to various state agencies. The Texas Comptroller of Public Accounts created the Texas Treasury Safekeeping Trust Company to manage public fund investments for the state. Money deposited with the treasury is generally pooled for investment purposes as pooling enhances the management of state liquidity needs, reduces risk through diversification, and realizes the benefits of higher investment returns attainable from economies of scale. In the past 12 months, the State of Texas Treasury Pool's assets have ranged from $15 billion to $20 billion. This pool of assets is being used for liquidity support to cover about $1 billion of outstanding bonds and its associated interest exposure. In 2002, Standard & Poor's assessed the State of Texas Treasury Pool's assets and determined that sufficient funds existed to provide liquidity support for all its outstanding bonds and has continued to monitor the pool's liquidity on a monthly basis.
CONCLUSION
Nearly 40 highly creditworthy tax-exempt and governmental entities have taken advantage of the Standard & Poor's liquidity assessment analysis as a cost-effective alternative to access the capital markets and provide coverage for failed remarketing on VRDO tender obligations and CP rollovers. These tax-exempt issuers have demonstrated the ability to provide full and timely payments from their restricted assets while reducing the event risks associated with bank rating actions and have an independent third party's opinion of their ability to do so. Although in a competitive interest rate environment, upon a cursory review, it may seem more economically feasible for an issuer to use an external bank liquidity facility, for some highly creditworthy tax-exempt issuers, this unique financing option may be a useful tool when reviewing all their financial options.
Note
(1.) The effective federal funds rate rose from 10.47 percent in July 1979 to 17.61 percent in April 1980, dropped back to 9.03 percent by July of that year, then rose to 19.08 percent in January 1981, dropped to 14.7 percent in April 1981, and finally peaked at 19.1 percent in July 1981 before beginning a steady fall and attaining a measure of stability by late 1982 at just below 10 percent. Source: U.S. Federal Funds Rate (effective), monthly record, accessed at http://www.federalreserve.gov/releases/h15/data.htmon.
KERI BADACH and MICHAEL MASIH are credit analysts with Standard & Poor's Ratings Services in New York GABRIEL PETEK, CFA, is a director and team leader in the state and local government group of Standard & Poor's Credit Market Services in San Francisco. To learn more about Standard & Poor's liquidity assessments, please contact Joel Friedman (joel_friedman@standardandpoors.com) or Guyna Johnson (guyna_johnson@standardandpoors.com).
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