Lease issuers' cost-cutting moves increase investors' risk, Moody's analyst says.

CORONADO, Calif. -- As interest rates continue to rise, municipal issuers are trying to cut costs by providing less security for lease deals -- a development that results in increased risks to the investor, a Moody's Investors Service official told a lease finance convention.

The higher risks could come in the form of reduced purchases of rental interruption insurance and a reduced amount of capitalized interest, two integral parts of a California lease, Nikolai L. Sklaroff, assistant vice president in Moody's San Francisco office, said late Wednesday.

Sklaroff's comments came during a session on trends in the municipal lease market at a California Debt Advisory Commission seminar in conjunction with the annual fall conference of the Association for Governmental Leasing & Finance.

In efforts to shave costs off the price of doing a lease financing, municipal finance teams are coming up with creative ways to reduce the amount of insurance coverage on the financing, he said.

The rental interruption coverage is essential to investor security because it guarantees continued payment on the lease should the asset become unusable, he said.

Deals with reduced nvester security would not be rated by Moody's, Sklaroff said.

For example, if it takes two years to build a school, the municipality should have two years' worth of reserves to cover the debt payments if the building became unusable in order to protect the investor, he said.

Another attempt to cut costs involves reducing the amount of capitalized interest on the deal, Sklaroff said. The municipality is not required to begin lease payments until it has full use of the asset, whether it's a fire truck or a building, but the municipality is required to hold moneys in reserve for the interim period. Municipalities have been trying to reduce the capitalization to a level that is unacceptable, he said.

"We recognize that insurance is an additional expense, and often a very costly expense, but there's no question" that the investor needs protection, Sklaroff said.

Overall use and acceptance of municipal lease financings is quite high, Sklaroff said, but the efforts to shave costs are causing the rating agencies to take harder and closer looks at all deals.

"We're in the business of evaluating risk and our policies have evolved to address those risks," he said.

It's important to ask why the municipality is using a lease financing in the first place, Sklaroff said. "Is it because you don't want to bring your project to the voter, you don't have time to go through the voter process, maybe you like the flexibility provided by a lease."

The rating agencies not only evaluate a municipality's willingness and ability to make payments, but all the circumstances that might prevent a municipality from having access to its assets, he said.

The market has been successful "at repelling the most offensive breaches," the defaults and non-appropriations, but the concern now is "the silent, slow attempts to erode investor security," Sklaroff said.

As a result, Moody's is more carefully reviewing all documents that are a part of the financing structure to make sure the essential documents are present, or if the amount of an insurance clause is too low, Moody's discloses that to the investor, he said.

Daniel Stone, an analyst in the San Francisco office of Standard & Poor's Corp., agreed with Sklaroff that investors and municipalities are comfortable with lease financing and that its use will continue to grow. However, one thing he hopes to see in future years is improved disclosure of essentiality, or how long an asset is expected to be useful to a municipality.

Municipalities can get into trouble when the use of a building does not remain essential throughout the life of the lease, and as a result Standard and Poor's rating criteria includes taking a closer look at whether an asset will remain essential to the municipality for the life of the lease, Stone said.

Overall, governments seem "pretty willing to repay issuances and treat them as debt even during these tough economic times," Stone said.

The "good side of things" is that ratings remain strong on both insured and uninsured lease debt, but the pressures on local budgets caused by the shifting of financial responsibilities from the state government to the local governments is going to "make it that much harder to carve out the revenues needed to pay for new leases, which will continue to be a drag on the market," Stone said.

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