Finance officials of the Palm Beach County, Fla., Solid Waste Authority said yesterday they are reconsidering an advance refunding proposed by Smith Barney, Harris Upham & Co. after concerns emerged that the deal may be too risky.
At issue for the authority is the deal's swap component, and the possibility that this leg of the transaction would be canceled under certain legal and market conditions.
According to the proposal, Smith Barney and the authority would negotiate the terms of the deal immediately, including a forward swap agreement and the pricing of the bonds. But the underwriters would issue $276.2 million of the authority's revenue bonds and complete the tax-exempt refunding in 1997. The swap would also take place that year.
At the moment, however, finance officials for the authority fear that they would face a multimillion dollar penalty if during the next five years they are forced to cancel the swap while interest rates fall.
That worst-case scenario became an issue of discussion two weeks ago during a meeting between the authority and its financial consultants, including the agency's financial adviser, bond counsel, and Smith Barney, the deal's underwriter.
During the meeting, Russell Hawkes, president of Florida Municipal Advisors Inc., the authority's financial adviser, said he would not recommend the deal unless Smith Barney develops a plan to eliminate any payment risk that would occur if the authority for some reason is legally barred from issuing tax-exempt debt during a time of falling interest rates.
Hawkes said the deal's current structure exposes the authority to this risk if, for example, new federal tax rules do not allow the agency to issue tax-free bonds, while market rates tumble about 300 basis points.
Under this scenario, which Hawkes termed "remote," the authority would be forced to ditch the swap transaction and face a penalty or "settlement fee" of about $59 million to the swap's counterparty.
Hawkes said the authority cannot sell tax-exempt bonds to make that payment. Without this ability, the authority must come up with the cash immediately, she said.
"I can't see that authority exposing itself to this kind of risk without being able to manage it," Hawkes said. "We are in the process of working on this now."
Other areas of risk to the authority include the possible inability of the swap counterparty, AIG Financial Products Corp., to perform its end of the deal.
Charles Maccarrone, the authority's director of finance, said that without Hawkes recommendation to proceed with the deal, the agency's board will likely veto the issue.
The seven-member board will meet today on the matter. Hawkes said Smith Barney is at the moment working on a solution to the authority's exposure. Smith Barney officials did not return telephone calls placed yesterday to their Palm Beach offices.
Market observers interviewed said the concerns raised by Hawkes are fairly common in the expanding municipal derivatives market.
Josh Siegel, a vice president of municipal financial products at First Boston Corp., said the municipal swap market "is not for everybody."
"The problem is that as people want less risk," he said, "the deals become more expensive."
In terms of the Palm Beach deal, the authority's finance officials say they stand to save between $10 million and $12 million on a prevent-value basis. Underwriters have termed the proposal a "synthetic advanced refunding," which includes an interest rate swap. The deal, if approved, would work like this: The authority would sign an agreement within the next two weeks to issue $276 million of floating-rate bonds in 1997 through a syndicate led by Smith Barney.
The deal is able to mimic an advance refunding because underwriters and the authority will agree on the terms of the deal immediately, but issue the securities at a later date.
By issuing the bonds in 1997, the call date of higher-yielding securities issued in 1984 and 1989, the authority can avoid the tax law restrictions on refunded debt. The securities have a maximum maturity of 2010; the variable-rate bonds are reset every seven days.
In order to protect the issuer from a rise in interest rates, the investment bank must also arrange a swap of interest payment for the authority. The swap allows the authority to achieve its goal of obtaining maximum present-value savings of between $10 million and $12 million if current market conditions prevail. That would be accomplished by locking into a fixed interest rate of about 6.50%, finance officials say.
AIG, as the swap's counterparty, would pay the floating rate to bond-holders. The swap payments to AIG, and the principal and interest to the deal's bond holders would be secured by AMBAC Indemnity Corp.