In Their Own Assets, Municipalities See Opportunity For Credit Enhancement
Constrained by tightening budgets, many state and local governments, and other entities nationwide are considering innovative financing techniques to sell their bonds. One solution many municipalities are turning to entails using existing assets, like pension funds and land grants, to guarantee local bond issues. While the phenomenon does not yet pose a threat to private bond insurers, the industry is watching the developments closely, particularly with overall volume expected to decline.
"I'm always worried that it's going to eat into our pie, but it's a fact of life," said Eric J. Shapiro, director of Financial Guaranty Insurance Co.'s general obligation, lease, and education group. "Sure we're concerned, [but] it's good public policy and [does] the taxpayer an enormous amount of good." Stephen J. Cooke, senior vice president and general counsel at AMBAC Indemnity Corp., agreed that state guaranty funds "may take business away" from the private firms, but doubted that "it would result in any material diminution of business."
Cooke said two questions must be addressed before states or other entities provide guarantees: Is the market in question already being served adequately by the private insurers, and is guaranteeing bonds an appropriate activity for the entity?
"From a generic perspective, we look at ourselves as being a broadly regulated, well capitalized business which has a real expertise that some of the other types of entities may not have at this stage," Cooke said. "As a broad matter, we [view] the market as [being] well served by the private insurers, but in those situations where that is not the case, then it's perfectly appropriate to structure a [guaranty] entity."
Thus far, insurers have faced the greatest competition from state or pension fund enhancements in the education sector, and "there is a very good reason for that," said Claire Cohen, vice chairman of Fitch Investors Service.
"Because education is the primary governmental responsibility," land was set aside for schools in the earliest days of many states, Cohen said. And the assets from those lands -- stemming mostly from minerals -- are now being used to insure bonds.
By far the most successful of these programs is the Texas Permanent School Fund.
Created in 1854, the Permanent School Fund did not begin backing debt until 1983. The fund's main source of income comes from state-endowed land, whose value grew rapidly because of oil and gas production. Income from the assets is now allocated to back local school district bonds.
The fund's guaranty capacity is restricted to twice its current book value, which was $8.7 billion on Jan. 31, according to Fitch.
The fund was only 32% utilized at Jan. 31, Fitch said, with guarantees outstanding on 725 issues totaling $5.6 billion.
Fitch, Standard & Poor's Corp., and Moody's Investors Service all rate the fund's claims-paying ability triple-A. In many respects, its financial strength far surpasses the private bond insurers, rating agency officials say.
In addition, using the fund costs municipalities very little, making it nearly impossible for the commercial firms to provide insurance for school districts in Texas.
"The Permanent School Fund is probably the finest state guaranty fund," FGIC's Shapiro said. "Before [the fund began to guarantee bonds,], FGIC and all the other insurers were doing tons of business with Texas school districts. Now we do next to nothing."
From Sept. 1, 1992, to Aug. 31, 1993, the last full school year, the Permanent School Fund said it guaranteed slightly more than $2 billion of bonds. In the same time period, $2.85 billion of primary school bonds were issued in Texas, of which only $192.8 million was insured by the private firms, according to Securities Data Co.
Undervalued for Years
For many years, bonds backed by the fund were undervalued, but recently that has been changing. In the past two years, bonds backed by the fund have begun to trade on par with -- or even better than -- those insured by the private firms, traders said.
The fund backs three types of bonds: new money old for construction or equipment, refundings with savings, and refundings without savings, according to Liz Caskey, chief accountant of the Texas Education Agency, which oversees the fund.
Other than the restrictions on "natural" AAA-rated school districts, no other credit criteria are required for the fund's insurance, which Caskey called "the beauty of the program."
~Some districts would have a hard time selling bonds if they needed to go to private insurers because they are not rated, and some are so small they can't get ratings," she said. ~The basis of the program is to afford low wealth districts the opportunity to sell bonds."
Predictably, the success of the Permanent School Fund has spawned imitations, notably in Wyoming and Oklahoma.
The Wyoming program takes the concept one step further in that bonds sold by cities, towns, and counties will be also be eligible for enhancement.
"Wyoming's program as envisioned is broader than Texas' in that they limit it to schools," said Dave Ferrari, Wyoming state auditor. "It was initiated here with the idea that there is a lot of local government debt that is not rated, and we felt that if we could pledge the permanent funds, we could improve the rating and lower debt service."
In February, Wyoming's legislature authorized a pledge of $100 million from the Permanent Mineral Trust Fund for the debt of local governments, and another $100 million from the Permanent Land Fund for school bonds.
State official are "in the process of developing the rules and guidelines" for the program, which should be up and running in about 90 days, Ferrari said.
Mary Keating-Scott, a vice president at George K. Baum & Co., which has been assisting Wyoming in developing the program, said that the Texas fund is the only other state program to have permanent funds pledged. As a result of Wyoming's similar structure, "the state is hoping for triple-A ratings," Keating-Scott said.
David Litvak, vice president at Fitch, said "we've been working with Wyoming to help them structure a triple-A guarantee."
Specifically, the rating agency is working with the state on "safeguards" for the gram -- like the leverage ratio, single-risk limitations, and investment rules for equity, Litvak said.
In Oklahoma, a proposal to allow the state's land commission to use its assets to provide a low-cost guarantee for school debt remains pending in the state legislature.
If approved, the program would authorize a guarantee of up to 2.5 times the land commission's assets, which total about $650 million.
Oklahoma officials expected to vote on the bill during the springs of 1993, but the session closed with law-makers "still wrestling with a wrinkle or two," according to Jim Joseph, the state's bond adviser.
During the current session, which ends May 31, Joseph said he "has not heard a word about it, [but] the bill is still alive, and state officials are hopeful it will pass in the next couple of weeks."
Several other states have guaranty programs for schools bonds, although they are structured differently than the Texas model.
In Minnesota, for example, the School District Credit Program uses a standing appropriation from the state's general fund to enhance local school bonds to the double-A level.
Michigan, New Jersey, and Virginia have similarly structured programs.
Originally, the Minnesota program was rated AA by Standard & Poor's and A1 by Moody's, and the split rating impeded its activity, market sources said. But when Moody's upgraded Minnesota's general obligation rating to Aa1 from Aa on March 28, the School District Credit Program also got a boost to Aa.
"Even though the state is required to make a general fund appropriation for the program, it's not a GO," said Dan Aschenbach, vice president and supervisor at Moody's.
Since the upgrade, sources said, the Minnesota fund has stepped up its activity.
Even though it has only been insuring bonds since August 1993, the program backed $276.6 million of tax-anticipation certificates, $331.4 million of general obligation bonds, and $39.1 million of GO refunding bonds as of March 15, Aschenbach said.
"It is quite a start for the program," he said. "And the state's cash flow still exceeds any monthly claim in principal and interest that would exist in a worst-case situation."
Robert R. Godfrey, executive vice president at Municipal Bond Investors Assurance Corp., said AA/Aa-rated programs like Minnesota's and the AA/A1-rated Michigan School Bond Loan Fund "aren't competitors" and could actually provide the private insurers with a business opportunity.
"We could be a companion product and ultimately help their issuers save more money by wrapping the double-A guarantee and bringing it up to triple-A, provided it was properly structured and administered," Godfrey said.
Outside the realm of state guaranty funds lie the significant holdings of pension funds, which some envision leveraging to insure bonds.
In June 1992, the Oregon Public Employees' Retirement System issued a guarantee on a $50 million taxable Port of Portland issue, ushering in the era of pension fund enhancements.
Clearing the Way
Last October, Standard & Poor's unveiled a rating criteria for pension funds, clearing the way for other to get into the guaranty business.
In January, the agency assigned its highest short-term ratings of SP-1-plus and A-1-plus to California State Teachers' Retirement System's [CALSTRS] credit enhancement and liquidity program.
"Our program is designed to facilitate transactions that will work in partnership with other financial institutions," said Patrick Mitchell, the system's senior investment officer. "It's designed that some other financial institution will take on at least half of the risk."
The system has "some prospects" but has yet to issue its first guaranty or liquidity facility, Mitchell said.
To date, CALSTRS is the only pension fund to apply for a Standard & Poor's rating, said Richard P. Smith, managing director at the agency.
"I think it's more of a potential than a reality at this point. But with the amount of money in pension funds, if they marshaled it [to guarantee bonds] it could be enormous competition" for the private insurers, Smith said. "But it's a very hit and miss type of situation. Even if they could, some pension funds may not be interested. The whole concept is in its infancy."
The major impediments to pension fund enhancement are questions of appropriateness, legality, and whether such activity can provide a high enough return.
"The pension funds' dilemma is that they've got to enter a business that's relatively safe and will generate a decent return," MBIA's Godfrey said. "I think their view has to be: Can we add value and get a fair return for the pensioners?"
The Port of Portland case raises the question of whether pension funds ought to get into the risk business because the corporate entity on whose behalf the bonds were issued, Pacific Aircraft Maintenance Corp., recently went into bankruptcy.
The bonds issued are not in default, and the Oregon Pension Fund has not had to pay claims because of other guarantees structured into the issue, Moody's officials said. But the scenario raises the specter of a large payout for pension funds, whose primary responsibility is to safely invest money for members' retirement.
A safer solution might entail a cooperative agreement, where the pension fund provided liquidity to floating-rate demand bonds and the private insurers guarantee the payment of principal and interest, Currently, only FGIC, through its FGIC-Securities Purchase Inc. affiliate, has this capacity.
"Providing liquidity may be a role the pension funds are more well suited for," AMBAC's Cooke said. "It's a potential partnership that might make sense."
Perhaps more ominous for the private firms, potential credit enhancement competition is on the horizon from government sponsored entities, known as GSEs.
In a report to President Clinton and Congress in February 1993, the Commission to Promote Investment in American's Infrastructure recommended creating a GSE to insure infrastructure bonds, modeled after Connie Lee Insurance Co.
The plan has reportedly been shelve, but bond insurers were in an uproar over the idea of competing with an entity backed by the U.S. government.
Meanwhile, other government entities are looking to get into the enhancement act.
With the passage of the 1992 Farm Credit System Safety and Soundness Act, the National Bank for Cooperatives, or CoBank, was given the legal authority to insure water and sewer bonds issued by rural communities with populations of less than 20,000.
When the act was passed in October 1992, two other local regional GSEs, St. Paul Bank for Cooperatives and Springfield Bank for Co-Ops, also received authorization to insure rural bond issues.
Jack Cassidy, senior vice president for corporate relations at CoBank, said the GSE has yet to insure any bonds as it is "negotiating" with the Internal Revenue Service to obtain an exemption to Rule 149B of the 1986 Tax Reform Act. The rule prohibits federal backing of tax-exempt bonds to prevent investors from "double-dipping" on the tax-free status of municipal issues.
The restrictions mitigate, but do not eliminate, the potential threat GSEs present to the bond insurers, industry sources said.
Elsewhere, federal officials are putting the finishing touches on a plan to create a bond insurance program for historically black colleges and universities. Provisions for the Historically Black College and University Capital Financing Plan were included in the Higher Education Act of 1992, and they commit the federal government to guarantee up to $375 million of outstanding principal and interest with a $357 million cap on principal. Neither CoBank nor the proposed entity to insure historically black colleges and universities worry industry executives, who point out that the agencies are structured for markets not traditionally served by the private firms -- and moreover cannot insure tax-exempt debt. However, insurance officials privately expressed concern that if these programs are successful, the government might consider starting similar ventures in the private insurers' markets.
Industry executives say they plan to continue to lobby hard in Washington against what they say are unecessary, and possibly risky, encroachments by the federal government into a market already well served by private industry.