Roll Your Own RECs

Letter-of-credit pricing to be pushed higher with small recourse for issuers, bankers warn.

The Bond Buyer June 14, 1991 | Boyle, Nicholas Issuers can expect to pay more for their letters of credit, both when borrowing in today’s market and when renewing the enhancements for older variable-rate transactions, according to a panel of public finance bankers.

Due to a convergence of deteriorating credit quality, international capital guidelines, and a sharp focus on return on equity, letter-of-credit banks are raising fees, the panelists said. And since the trends are market-wide, public entities will have little competitive recourse.

“The banks are looking at risk weights, the [issuers'] credit condition, and their ROE,” said M. Susan Kish, vive president and manager of public finance at Union Bank of Switzerland. “The short-term impact for issuers is that it probably will increase costs; in the long term, it should be a more efficient, stable market for everybody.” Ms. Kish spoke at a conference sponsored by the Institute for International Research entitled “Minimizing Investment Risk and Issuer Exposure in Letters of Credit.” Other panelists included Timothy J. Kiley, vice president of capital markets at Bankers Trust Co., and David J Sellers, vice president of public finance at Sanwa Bank Ltd. Together, the officials represented the three major groups of letter-of-credit providers — the Japanese, the Swiss, and the Americans.

“The cost of admission is going higher,” said Mr. Kiley of Bankers Trust. “And issuers are lucky if their seven-year [letter of credit] is being renewed at the same price; it’s probably being renewed at a higher price.” Even when issuers want to abandon a bank because its credit quality has declined, he said, replacing letters of credit can turn out to be too punitive. “The costs might offset the quality upgrade,” Mr. Kiley said.

The European banks are more actively ferreting out the higher fees, he added, but the strategy includes taking on more risk than is typical with the market-leading Japanese.

“The Europeans seem a little more disposed to taking greater risks, but they certainly want to get rewarded for it,” Mr. Kiley said. Unlike the Japanese, “they don’t want to fall all over themselves to do an A-plus credit.” Mr. Sellers of Sanwa said prices have increased noticeably in the last six months, but he emphasized that the market still embraces a wide pricing range for each different credit group. “There is a difference of opinion on exactly where the market is,” he said. website letter of credit

Water and sewer liquidity facilities, for example, command 30 to 50 basis points, while a line of credit supporting a state GO borrowing can cost from 13 basis points to 40 basis points, Mr. Sellers said. Only a year ago, water deals fetched about 22 basis points and lines of credit were sold for as little as nine basis points.

The price firming is partly a function of deteriorating credit quality among U.S. polities. “Troubles here make news overseas and influence the approval of bank LOCs,” Mr. Sellers said. “It makes it more difficult for those issuers most in need of the LOCs.” Ms. Kish, at the same time, rejoined that banks providing letters of credit are having second thoughts about larger deals and gross exposures, and the result is a more selective enhancement strategy industry-wide. “Banks are experiencing a lot of pressure on supply, so they’re husbanding their credit; they don’t want too much out there,” she said.

One of the offshoots is an eagerness to “participate out” the deals, or reinsure part of the risk with other letter-of-credit banks, Ms. Kish added. But obtaining approval for other banks from increasingly hard-line credit committees is proving more difficult, as institutions become skeptical of one another’s capital strength, and the result is fewer borrowings backed with letters of credit, she said. site letter of credit

Mr. Sellers also noted “the weaker participation market” and said the development is leading to more syndicated deals, where banks share the up-front risk rather than one lending its credit support to the whole issue. In fact, the trend has progressed to the point where syndicate groups are now competing for deals that only a year go would have been taken by one bank alone, Mr. Sellers said.

A prime example is the line of credit for Washington Suburban Sanitary District’s new $426 million commercial paper program, which Union Bank of Switzerland and Canadian Imperial Bank Corp. won together for 18 basis points, according to Joe Kerrigan, director of investments and funding at the district. The two banks beat out a syndicate of Dai-Ichi Kangyo Bank Ltd., Mitsubishi Bank Ltd., Sanwa Bank and Sumitomo Bank Ltd.

On Wednesday, the district approved the deal. The documents are scheduled to be signed June 26, and the first $190 million leg is tentatively slated for July 1, Mr. Kerrigan said. Next year the second, $235 million leg of the deal will be sold, with the maximum allowable debt outstanding being $265 million.

Mr. Kerrigan said the syndicates’ bids are clearly higher than in the past.

“Their fee is up substantially,” he said. “On our 1989 deal, [Dai-Ichi Kangyo] provided the liquidity facility for nine basis points. Then they were looking to get market share. Now they have it.” A Major concern of issuers today is the renewal of their letter-backed transactions put together in 1984 and 1985. The majority of letters had seven-year terms, so many borrowers and banks are currently negotiating new contracts.

Mr. Kiley of Bankers Trust said about $55 billion of letter-backed deals were done solely to beat enactment of the Tax Reform Act of 1986 — as issuers seized what looked like the last opportunity for arbitrage gains — and that those renewals appear to fall into three broad categories:

* Issuers whose deals continue to earn arbitrage, so the borrowers have an incentive to keep the deal outstanding.

* Deals that are majority owned by companies whose balance sheets are improved by the enhanced variable-rate demand bonds.

* And borrowings sold by issuers precluded — either by prohibitive costs or regulations — from converting their debt to long-term securities.

Boyle, Nicholas