While the lending environment continues to be very challenging, it can present unique opportunities for financial institutions that have not been available for many years. One such opportunity that we wanted to bring to your attention is in the area of direct tax-exempt loans (i.e. loans made directly to a municipal entity or to a non-profit corporation through an authority).
In recent years, the majority of large tax-exempt projects for either municipal entities or non-profit corporations have been financed through the issuance of either fixed rate bonds insured by one of several bond insurance companies or variable rate demand bonds (VRDBs), which are long term, taxable or tax-exempt bonds issued on a variable rate basis that can be tendered for purchase by the bondholder at par upon seven-day notice. The VRDBs were often supported by a letter of credit from a financial institution to provide liquidity for a tender if a remarketing agent is unable to resell the VRDBs. While VRDBs were often great options for borrowers, the rates chargeable by financial institutions on letters of credit paled in comparison to the margin available to such financial institutions when making conventional loans. As a result, many financial institutions shied away from bidding on potential tax-exempt projects and sought to use their capital in other ways.
Both the fixed and variable rate marketplace have recently undergone significant adjustments. On the fixed rate side, the bond insurance companies that were active in the market have been downgraded and most issuances now look to trade on the underlying issuer rating (which means many entities will be effectively out of the market if they do not have an individual rating). On the VRDB side, the recent turbulence in the marketplace has placed severe pressure on remarketing agents who are having great difficulty finding willing buyers. Since underwriters and remarketing agents are having enough trouble selling existing bonds, new bond issuances are hard to come by. As a result of these developments, the current trends in muncipal finance present financial institutions with two specific short-term opportunities.
First, for any new projects that are planned to occur in the first half of 2009, we are advising our borrower clients that VRDBs as well as most fixed rate bonds are likely not a viable option in the current environment. This may include sizable projects such as sewer and water projects and school district building projects that might otherwise have utilized fixed rate bonds or VRDBs. Loans to such municipal entities are of historically minimal default risk, generate tax-exempt interest earnings and have the possibility to garner higher fixed interest rates than in the recent past. In today’s environment stressing risk avoidance, municipal loans are the ideal place to put capital to use.
Second, refinancing existing VRDBs into a conventional tax-exempt loan may be attractive to many borrowers. Since VRDBs are floating rate obligations, many borrowers were surprised by the dramatic increase in interest rates which occurred in the fall of 2008. During that time, typical interest rates on tax-exempt VRDBs approached 5.5% and interest rates on taxable VRDBs approached 7% (not to mention the upset rates included in many issuances in which interest rates spiked to over 10% when the bonds could not be sold). Interest rate swaps put into place to mitigate interest rate risk proved unsuccessful in many instances. In addition, many financial institutions are now increasing the letter of credit fees payable on standby letters of credit supporting these VRDBs. This has made many borrowers desire true fixed rate debt instead of any synthetic product.
One additional point which may favor direct tax-exempt loans is the new stimulus package currently making its way through Congress. Under one iteration of the package being discussed, financial insitutions would be able to deduct 80% of the cost of buying and carrying tax-exempt obligations from municipalities which issue less than $30 million per year, an increase from the current limit of $10 million. This has the potential of making the pricing on direct tax-exempt loans much more competitive for larger projects.
As the marketplace continues to evolve, we invite you to contact a member of our Municipal Finance Team with any questions concerning a specific transaction, or about the general process of making available a tax-exempt loan, as there are many pitfalls to avoid. As always, we value our relationship with you and would appreciate it if you would continue to keep us in mind as opportunities arise for referrals.