Sanwa Bank has rejected a request by the Philadelphia Water Department to extent an expiring letter of credit, leaving department officials scrambling for alternative credit enhancement.
About $88.5 million of outstanding notes are at stake. If another bank cannot be located to guarantee the notes, the issue could be converted to a fixed-rate mode early next year.
Another $35.4 million of water department bonds are likely to face the same fate when another Sanwa letter of credit expires next September, according to Ronald Coy, a deputy commissioner at the water department.
"I assume if they don't want to hold this one, they won't want to hold that one," Mr. Coy said.
The expiring contract for the water department's bond anticipation notes -- a $124 million deal under-written by Goldman, Sachs & Co. in 1985 -- requires Sanwa to continue backing the notes after the expiration date until a conversion or alternate provider is found. But the department must pay Sanwa a penalty rate equaling the prime rate plus two points, Mr. Coy said.
Given Sanwa's decision, the department is now faced with finding an alternate letter of credit provider, converting the notes to fixed-rate rate securities, or bonding out the obligation. Mr. Coy said he and officials from the Philadelphia treasurer's office have been trying to find an alternative letter-of-credit provider, so far without success.
Officials at Sanwa could not be reached for comment Friday. But Mr. Coy said Sanwa had conveyed its strong desire to dtop its exposure to the water department, expressing concern that if it agreed to the request for a three-month extension, it would only be asked to extend the letter again when that deadline arrived.
The water department has already secured a commitment from Smith Barney, Harris Upham & Co. to underwrite a conversion to fixed-rate bonds if the department decides to go that route -- which Mr. Coy said should signal that the department was acting in good faith to find an alternative to the Sanwa letter.
Bondholders are still protected if the enhancement negotiations hit an impasse, said Roxanne Booth, assistant vice president at Moody's Investors Service.
"If the letter of credit is terminated, there will be either a mandatory tender or an acceleration," she said, "and bondholders will receive the bonds at the purchase price plus interest."
Sources involved in the deal said all of the bank involved in the letter want out, but most, including Sanwa, are actually willing to extend the letter until March. The problem, one source said, is that Mitsui Taiyo Kobe Bank, which participated in the letter, declined to extend the large portion of the guarantee it assumed from Sanwa.
Mitsui's ratings are among the lowest of Japanese credit enhancement providers, and market sources have speculated the bank is being forced to gradually withdraw from the municipal business. Marc Kremer, an assistant vice president at Mitsui, said work on the city water deal is still under way and declined to comment.
Renewing letters of credit had until recently been a matter of course -- issuers and banks would rubber stamp new documents and extend the guarantees for the same contractual terms. But several changes on the international banking scene over the past year have combined to make the renewal process less certain, especially for weak credits like Philadelphia.
"We are seeing resistance [to renewals] in many cases on the part of the banks." Ms. Booth said. "When they have a choice to get out, they get out on the expiration date. That's their only chance."
Last year's Tokyo stock market crash and the phase-in of international capital standards resulted in steady erosion of Japanese bank ratings. In the United States, similar capital standards and the real estate collapse wiped out credit quality nationwide.
As a result, banks that used to welcome municipal business are backing out, unwilling to commit precious capital to areas of relatively low rates of return. The banks that do stay on, meanwhile, are demanding higher fees or "tighter covenants," according to Ms. Booth.
Moody's rates Sanwa's long-term letters of credit Aa1 and has the rating under review for possible downgrade. The agency recently downgraded Mitsui Taiyo Kobe to A1 from Aa3. Both banks have Prime-1 short-term ratings.
Standard & Poor's Corp. rates Sanwa AA and A1-plus for short-term obligations, while rating Mitsui A-plus and A1, respectively.
The water department's credit picture has brightened in recent months, following a plunge last year to junk status when the city's general obligation rating sank to triple-C. Until last June, the city mingled water revenues in its general consolidated cash account, leaving the department exposed to Philadelphia's ongoing brushes with insolvency.
That situation was fixed in June when the revenues were segregated, prompting an upgrade that brought the department back to investment-grade status. But Michael Johnston, a manager in the public finance department at Moody's said the agency's Baa rating is back under review because of worse-than-expected operational results in recent months.
Mr. Johnston said the expiring letter of credit is not yet considered a major credit problem, but would promt a rating statement next year if a conversion takes place and new debt is issued.
Mr. Coy said the bank officials with whom he has spoken do not even care to discuss credit issues, and have offered few reasons for their refusal to extend the letter.
"They don't even want to renegotiate a fee," Mr. Coy said. "They just want out."
The water department official said the best possible outcome would be for a new provider to pick up where Sanwa left off. Short of that, he said bonding out the notes is preferable to a simple conversion because of the greater flexibility a new issue would afford.
