DENVER -- Lease-purchase financings could be called time bombs because of various risks, but they are gaining greater acceptance among investors, according to speakers at the Government Finance Officers Association's annual meeting here this week.
The financing are threatened by natural disasters, unfavorable court rulings, and poorly structured financings; but at the same time, spreads between them and general obligation bonds have narrowed, said speakers at a session titled "Lease-Purchase Financing: Viable Debt Alternative or Political Time Bomb?"
David Klinges Jr., a senior vice president at Lehman Brothers in Philadelphia, warned that a natural disaster like the 1989 California earthquake could cause investors to look more closely at the lease industry.
"There is a chance to market may scrutinze leases to a greater degree due to future events," he said.
A natural catastrophe, he said, could wipe out facilities being leased and, in some cases, eliminate the obligation of the lease agreement. He noted, however, that no public default on a rated debt resulted from the California quake.
Mr. Klinges said investors should consider the potential for future events that could affect the debt service payment on lease-purchase bonds. He added that the issuers should familiarize themselves with the legal aspects of the lease-purchase bonds to understand their liabilities.
But are these deals a political time bomb?
"Only time will tell," he said.
Alfred Medioli, a vice president at Moody's Investors Service, said "an unpredictable event" involving a court ruling also could contribute to the time bomb label for lease bonds.
As for these lawsuits that are brought against municipalities, usually by taxpayers groups opposed to lease financings, Mr. Klinges said it was important for issuers to understand the legal requirements that govern these kinds of financings. He added that issuers should be prepared for legal setbacks, such as the recent adverse court ruling in Virginia.
In that ruling, the Virginia Supreme Court ruled that even though a regional authority was supposed to issue the lease bonds -- because tax receipts of Fairfax County were to repay the bonds -- the debt would be the county's and therefore needed voter approval.
But Mr. Klinges pointed out that in 1991, over all, court cases have succeeded in upholding the use of leases by municipalities.
Mr. Medioli said poorly structured lease deals have become a bigger issue as more private entities become involved in an intermediary role as lessor.
According to Moody's, bondholders could be at risk because entities such as banks, private companies, or other privately owned groups can go bankrupt.
If a bankruptcy occurs, bondholders could suffer if the lease payments are considered a secured loan and found to be part of the bankruptcy estate. Payments to bondholders could be reduced or eliminated, the rating agency said.
A recent Moody's credit report suggested two solutions to the private-entity bankruptcy problem. One would be to structure the transaction to insulate the debtholders from that risk. The other way would involve factoring the rating of the private entity's direct debt into the lease transaction's rating.
Mr. Medioli said another risk to lease financings is that they are subject to annual appropriation.
He said those types of leases occur "in their purest form" in Kentucky and Colorado, where municipalities on an annual basis "terminate the lease free and clear."
"The only action the trustee can take is to sell the asset and distribute the proceeds to bondholders," he explained.
But on the plus side, Mr. Medioli pointed out that Moody's has 1,500 ratings on leases or certificates of participation that the agency does not consider risky. He said most potential structural problems in these types of bond deals are caught during the rating process.
Another bonus for leases is investors' growing acceptance of them.
"Right now, I think the market is as comfortable as it ever will be in the use of these securities," Mr. Klinges said.
He pointed out that what was once a 200-basis-point difference between the rates on leases and those on GO bonds has shrunk to 20 to 30 basis points.
"The large part of the reason is because the history of public lease securities is rather short and the default rate on publicly offered, rated securities is virtually nil," he explained. "Investors have gotten so comfortable because of that track record."
He said the only defaults that have occurred have been in privately placed, unrated issues.
Michael Buckley, a vice president at T. Rowe Price in Baltimore, said institutional investors, such as funds, grew more interested in leases and certificates of participation in the 1980s. He attributed this to higher yields on the bonds, improvements in disclosure, and the willingness of municipal bond insurers to insure these kinds of issues.
Mr. Buckley said, however, that larger investors would like to get "timely and accurate" disclosure documents several days before the actual sale of the bonds.
Besides insuring the issue, he listed several security features that would be attractive to institutional buyers, including: a fully funded debt service, guaranteed maximum or fixed-price construction contract; performance bonds covering the entire cost of construction; alternative uses for the leased property; a useful life of the facility that exceeds the lease term; and "clear legal case law" supporting the financing technique.
