When Rebecca Rhynhart looks over plans expanding the Pennsylvania Convention Center, the Philadelphia city treasurer sees more than additional space for holding meetings and expos.
In a very real way, Rhynhart is looking at bonds — at the IOUs the state will issue to raise a couple hundred million dollars to fund the project. States and cities issue bonds all the time, to build water systems, roads, police stations, schools. All the infrastructure you see around you is funded with bonds.
And wherever they begin in America, those bonds go through the center of global finance, Wall Street. The system worked pretty well until recently, when problems started with relatively new ways of issuing bonds. In the 1990s, cities made the move from fixed-rate bonds — which paid a predictable amount of interest — to variable-rate bonds.
For cities, the variable-rate bonds seemed to offer a cheaper way to raise money. They wouldn't get stuck paying high rates over a decade or two, if the interest rates fell after the original loans were made.
"I think they were popular," Rhynhart says. "They offered what looked to be a lower all-in cost."
But what looked to be and what turned out to be were very different.
What Is A Liquidity Bank?
In order to begin understanding what has gone haywire in the once boring world of bonds, you need to understand a situation like Rhynhart's. She needs to do two things before she can issue a variable-rate bond. She needs to get insurance from a special insurance company that insures bonds. And she needs to get a bank to agree to be something called a "liquidity bank."
The way you make a variable-rate bond work is by having a liquidity bank attached to it. This liquidity bank is, essentially, a safety net. If you own a variable-rate bond you want to sell, and can't find a buyer for it, the liquidity bank promises to step in — to be the buyer of last resort.
Every variable-rate bond issue has to have a liquidity bank attached to it. And who was one of the biggest liquidity banks out there?
The answer is Depfa, an Irish bank with a German owner, the same bank that lent to a string of five school districts in Wisconsin.
Rhynhart has seen her own chain of unfortunate events. "We do have some bonds that have Depfa as the liquidity bank, and they are almost all in the liquidity bank, because no one wants to buy them," she says.
That's bond-speak for: "Something has gone very, very wrong."
When Normal Stopped
The job of a liquidity bank like Depfa seemed simple: Collect a small yearly fee in exchange for being the liquidity bank, and never be called on as a backstop.
If I have a variable-rate bond that I want to get rid of, I hand it back to the Wall Street firm managing that bond, and that firm finds another buyer in seconds. The $2 trillion market in bonds worked so routinely and so seamlessly that it was basically invisible.
The notion that a variable-rate bond couldn't be remarketed — that's the technical term for "sold to someone new" — was ludicrous.
But this year, that notion went from ludicrous to frighteningly real. The problems began with the insurance companies. And a handful of insurance companies covered municipal bonds, firms like MBIA and FGIC and Ambac. Late in 2007, these firms found their credit ratings slipping.
Kathy Clupper works for a company that advises municipalities about bond issues. A 20-year veteran of the industry, she describes this as a big deal.
"When we started hearing that the bond insurers were getting downgraded, it was unbelievable," she says. "Nobody ever considered that a AAA bond insurer would get downgraded. Or that all of them would get downgraded."
No one considered it because, historically, insuring municipal bonds was not risky business. Municipalities almost never default on their bonds. The cumulative default rate on all municipal bonds issued between 1987 and 1994 was less than 1 percent. The library never misses a payment; the school district never misses a payment. The city of New Orleans, even after being devastated by Katrina, didn't miss a payment.
So how did these bond insurers, who collect premiums and never pay claims, manage to get themselves downgraded? Earlier this decade, they started insuring something besides municipal bonds: subprime-mortgage-backed securities. Enough said.
The bond insurer downgrades had consequences for Philadelphia treasurer Rhynhart. Her office issued $290 million of variable rate bonds last year. It used one of the main AAA bond insurers out there, a company called FGIC. Everything was going fine, until FGIC got downgraded.
"And [to] investors suddenly it was, 'I own this bond, and it has this FGIC name on it ... I don't want to hold this bond anymore,'" Rhynhart says. "That insurer, that was supposed to protect and provide some extra bondholder security, they become the burden on the deal, rather than assisting us on the deal."
The burden specifically was when no one wanted the bond — that's when the liquidity bank, the buyer of last resort, has to step in. Banks like Depfa. But these banks were reluctant saviors. They didn't want to own these bonds either. It's a big hassle to buy them. And when they do it, lots of fine print kicks in. The interest rates go much higher, and the terms, in some cases, shrink. So a town that thought it had 30 years to pay its debt, when the bond goes back to the bank, it now has 10 years, or seven years. Its payments skyrocket.
Clupper's client, a school district, is in just that situation.
"They may have budgeted, you know, $1 million a year for this bond issue; now they all the sudden have to pay $2 million or $3 million in principal that they hadn't budgeted, and that's significant for a lot of school districts," she says. "So now they have to pay more, more in interest and more in principal."
The Ripple Effect
And the problems don't end there. In the case of Depfa, its financial situation is so bad that it has been downgraded as well. And that makes it even harder to find a new buyer for a bond with its name on it, because if both the insurance company and the buyer of last resort might not be around to fulfill their obligations, now investors really aren't interested.
And so all across the country, towns and cities are stuck. They have their bonds at the bank, with rapidly increasing interest rates and payment schedules.
"There's no bond insurers that are out there, to step in the shoes of the FSAs and FGICs and the Ambacs," Clupper says. "So there's no moves left for a lot of these municipalities."
Rhynhart and Clupper both say that the municipalities will figure some way to keep making their payments. They always do. But it'll cost them, and by extension, everyone — in slightly higher taxes, or water rates, or hospital bills.
The kicker of this whole thing is that the municipalities are only doing what they've always been doing: issuing bonds, and paying them back with interest. It's the institutions that were supposed to guarantee them, the insurance companies and the liquidity banks, that have gotten in trouble. It's as if you bought auto insurance, and then your insurance representative came over to your house, got liquored up, totaled your car, handed you back the keys and said, that'll make your rates go up. Everything is upside down.
And all over the country, municipalities are learning the same lessons that the school districts in Wisconsin learned, and that the board of the bank of Depfa learned.
Complexity can make things more efficient, and going global can make you money or save you money, but it also exposes you to risks that you might not foresee. If the school districts and transit agencies didn't understand that trade-off before, they're getting a painful lesson now.