Competitive bidding spread to an unlikely corner of the municipal market last week, as the Illinois Health Facilities Authority entered a 30-year interest rate swap through an informal bidding process.
Originally, the authority planned to sell fixed-rate bonds on behalf of Rockford Memorial Hospital. But after the market soured in early April, senior manager Lehman Brothers suggested a synthetic fixed-rate structure that combined a variable-rate bond issue with an interest rate swap.
Under the synthetic fixed-rate structure, Lehman would sell $75 million of variable-rate bonds reset at a monthly auction and enter a swap with the hospital in which Lehman would pay the bond rate and the issuer would pay Lehman a fixed rate. The hospital anticipated that Lehman would provide the swap in a negotiated transaction.
The swap covered $45 million of the variable-rate bonds and had an identical final maturity in 2024 and an identical amortization schedule. The remaining $30 million of variable-rate bonds would remain a floating-rate liability for the hospital -- about 22% of the issuer's total long-term debt outstanding, according to an official on the deal.
But as the issue moved toward final pricing, the authority and its financial adviser, Ponder & Co., grew uncertain about the fixed rate offered by Lehman on the swap.
At first, Ponder officials sought other bids on the swap simply to gauge the market and insure that Lehman's bid was acceptable.
"We wanted to get comfortable with the rate that was proposed, but we got indications of lower rates in the marketplace," said Beson Caswell, vice president at Ponder. "The problem is that those providing the [other] rates are not in the position of being taken up on their proposal. They could be lowballing the deal."
Also, swap providers in the market did not provide price quotes based on the same terms and structures contemplated by Lehman, an official at the firm said.
The authority decided to try to put together a competitive bidding process that would allow other firms not only to quote a price for the swap, but also be in a position to win the business. Euro Brokers Capital Markets Inc. acted as the agent for the bidding process.
The authority pt together a list of required features and terms and circulated it among possible swap providers. There was some feedback from the market and the terms were changed slightly from the original requirements.
However, the bond component of the deal was already structured by Lehman Brothers using the firm's Select Auction Variable Rate Securities. Lehman pioneered the synthetic fixed-rate structure that includes long-term, auction-set bonds last year on a deal for Bakersfield Memorial Hospital in California.
Some swap providers were uncomfortable with the structure. A more common structure uses variable-rate bonds reset by a remarketing agent and carrying put rights and liquidity backing.
When the swap was finally priced April 26, only Lehman and TMG Financial Products put in bids. Lehman had the lowest bid, with fixed rate of 5.94% paid monthly and a three-basis-point fee for acting as the auction agent.
If the authority had sold fixed-rate 30-year bonds that day, it would probably have received a rate of 6.45% at the long end and an average coupon of about 6.35%, Caswell said. On a bond equivalent basis, the swap rate came out to about 6.05% -- a savings of about 30 basis points, he said. A Lehman Brothers official said the savings were closer to 20 to 25 basis points.
TMG also proposed a structure using the more common puttable variable-rate bonds with liquidity backing, but Caswell said the issuer did not have sufficient time to consider restructuring the entire deal.
"There just, wasn't time to change," Caswell said, although he praised TMG for "being creative and sticking with the deal all the way through."
In the end, the authority was a big winner, he said. Although the cash market moved somewhat, the fixed rate on the swap was significantly below the rate Lehman initially quoted before the competitive bidding process, he said.
But Gary Killian, managing director at Lehman Brothers, defended the firm's pricing procedures. "Our pricing methodology was consistent throughout the transaction even to the point where the FA involved us in a bidding process," he said.
Killian attributed changes in Lehman's swap price to changes in the swap market, which are caused by movements in the short end of the Treasury market as well as in the long end of the municipal market.
Caswell said issuers looking at competitive bidding on swaps should try to adopt standardized documents and terms, allow time for potential bidders to review their credit standing, and allow "ample time for the working group to strategize and build in flexibility for the bond issue."
Although swaps are highly customized with regard to features such as termination payments, collateral requirements, and amortization schedules, Caswell said the competitive process did work for the authority and could be used in the future.