Mitch Daniels and State Government and Bonds and Government & Economic Development and Government

Bond market turmoil could raise costs for stadium, other projects

February 25, 2008

The debt strategy Gov. Mitch Daniels' top financial officials developed to save the state money on major projects like Lucas Oil Stadium has turned sour.

To pay for construction, the administration over the last few years issued $810 million in "auction-rate" bonds--a form of variable-interest-rate debt that once promised to shave costs. But this month's unexpected meltdown of the U.S. auction-rate securities market has opened the state to risk of sudden spikes in interest.

And now, to avoid extraordinary payments for debt service, Indiana may have to spend millions of dollars on fees to issue replacement bonds.

As far as Wall Street credit rating agencies are concerned, the sooner Indiana addresses its problem, the better.

"We'd expect for a state as highly rated as Indiana, in this situation, that they would take some sort of action relatively quickly," said Nick Samuels, a vice president for New York-based Moody's Investors Service. "The state certainly understands what this issue is. And my understanding is they're working on finding a solution."

Auction-rate bonds are long-term securities that behave like short-term debt. Interest rates on the debt are reset through auctions staged no more than 35 days apart. The Daniels administration turned to the burgeoning auction-rate market in a bid to keep interest costs low on major projects.

But over the last month, the once-obscure auction-rate market has become the latest victim of the global credit crunch. Recent auctions have failed to generate sufficient investor interest, raising the specter that interest rates on state projects could soar from the low single digits to 15 percent or more.

When Daniels' Republican administration began issuing bonds for the $700 million Lucas Oil Stadium project in October 2005, the auction-rate market looked like a good deal. The state decided to finance the entire project with auction-rate securities. The Indiana Finance Authority has issued $600 million for the project so far.

The state also is responsible for $170 million in auction-rate debt related to Indianapolis International Airport, plus $40 million for other state building projects.

Ryan Kitchell, director of the Indiana Office of Management and Budget, downplayed the state's challenges, saying it intends to refinance. And because early interest costs on Lucas Oil Stadium bonds were below expectations, he said, the state now is positioned to absorb higher-than-expected rates.

But not all financial experts think the state's bet on the volatile market was wise.

Tom Fischer spent two decades as an investment banker and financial consultant before becoming chief financial officer of Community Health Network two years ago. He said he always counseled his clients to avoid auction-rate debt, and Community has none on its ledger.

"To be honest, I could never get comfortable with the risk," he said.

The Democratic gubernatorial administrations of Frank O'Bannon and Joe Kernan also did not tap that market, said Diana Hamilton, who ran the predecessor to the Indiana Finance Authority for both men.

"Not because I'm so much smarter than everybody else. It was really just a pricing thing," she said. "These things change in the market a lot, and typically with auction-rate debt, you need to purchase bond insurance. And also the ... fees paid to the investment banker were higher."

Ironically, if the state had issued traditional variable-rate bonds, it would now be enjoying a windfall thanks to the Federal Reserve's campaign to lower interest rates.

Market meltdown

Auction-rate debt debuted as a financial instrument in 1984, according to Moody's. By last year, there were $328 billion in auction-rate securities on the market. Failed auctions were long a rarity: Just 13 flopped before the end of 2006. But since then, 63 bond-rate auctions have failed. And 32 of the failures occurred since January, spurring a panic.

Moody's expects more trouble ahead, even though many of the bonds were issued by financially stable governments, hospitals universities and utilities.

"Conditions since the middle of 2007 have changed dramatically. The auction-rate market has now been severely disrupted," in part because of financial woes facing the bond insurers that are supposed to step in and pay should governments default, Moody's wrote in a Feb. 20 special report on the auction-rate market.

"We would expect additional auction failures in the next days, weeks and perhaps even months. This outcome is possible notwithstanding the fact that the underlying credit quality of issuers remains strong in the short term, even as interest rates spike up."

The Wall Street Journal reported that the Port Authority of New York and New Jersey saw interest rates on $700 million in auction-rate debt shoot up from 4.2 percent to 20 percent on Feb. 12--a spike that ballooned weekly interest payments from $83,611 to $390,000.

Auction-rate bond issuers across the country are now scrambling to avoid a similar situation. The Indianapolis Bond Bank, for example, is attempting to refinance $50 million in auction-rate bond debt the city holds for improvements to its waterworks.

Executive Director Kevin Taylor said he's thankful Indianapolis hasn't issued more auction-rate bonds for other projects.

"Our exposure is very limited, I'm glad to say," Taylor said.

Kitchell, the director of the state Office of Management and Budget, said that on Feb. 19 the Indiana Finance Authority developed a refinancing plan in response to the deteriorating market.

He said that, until recently, interest rates on the stadium bonds were lower than the 4 percent the state had forecast, though in the last few weeks they topped 5 percent. A swap agreement built into the bonds is slated to fix the rate permanently at 4.23 percent once the project is finished this fall.

The highest interest rate permitted under the existing bonds is 15 percent. But Kitchell is confident the state will successfully refinance, avoiding any chance of that worst-case scenario.

Indiana Public Finance Director Jennifer Alvey is researching the cost of quickly refinancing the $600 million in stadium bonds and $170 million in airport-related bonds. The state is contemplating either moving the debt into another type of variable-rate bond, or into new fixed-rate bonds.

Because the bond insurer backing the $40 million in other auction-rate debt hasn't shown problems yet, Indiana is taking a wait-and-see approach on those bonds.

Alvey said she is busy "crunching the numbers" and can't yet estimate the cost of the state's imminent debt transfer.

"We just want to stay in front of it and try to change to a different mode where we have lower interest rates and take care of it," she said.

Cured quickly, or incurable

But it could be expensive.

John Reed, executive vice president of Chicago-based investment firm David A. Noyes & Co., said Indiana will have to pay for agencies to rate the new bonds, as well as underwriting fees, brokers' fees, legal fees and insurance. The state's costs for a new issue could top $10 million, Reed said.

And that assumes the auction-rate securities market's meltdown doesn't spread to other sectors of the bond market.

"At the moment, the credit markets are in phenomenal disarray. It's going to be different this afternoon than it is this morning. These markets are very thin, and they can dry up," Reed said. "A lot of these problems are either going to be cured quickly, or become incurable. You just don't know."

Another challenge is that many other governments also are flocking to refinance, said Craig Johnson, an associate professor in Indiana University's School of Public and Environmental Affairs who's researching the auction-rate market. Banks are overwhelmed with requests for credit, he said, and Indiana will have to wait in line.

"It's going to be expensive [to refinance]," he said. "Especially if a lot of these securities are hitting the market at the same time."

In better times, Community's Fischer said, investment banks pushed auction-rate bonds over other more-vanilla types of debt. They'd argue that the lower interest rates justified the higher fees governments paid. Now, he said, the rush out of the auction-rate bonds will drive up fees for other refinancings.

He said the biggest problem he had with auction-rate debt was that "borrowers took all the risk, and the investment banker crowd made a lot of money off of it. And in many cases, they sold it to people who had no basis being in it to begin with. I hate to be a cynic, but that's the way it is."

University of Indianapolis finance professor Matt Will thinks the current anxiety is overblown. He said there always will be a market for bonds supported by stable governments, though the borrowers might have to pay more in fees to refinance than they'd like.

Still, experts agree it would be unwise for governments to hold tight and hope the auction-rate storms blow over.

"Most underwriters in my business are saying auction-rate securities are going to be dead in the muni market for the foreseeable future," said Brenda Horn, a partner with Ice Miller LLP. "So you just need to get out of them."

Hamilton, the former finance head for O'Bannon and Kernan, said she's reluctant to second-guess her successors in the Daniels administration for their choice to use auction-rate bonds. Hamilton noted that she made her decisions under completely different market conditions.

"I don't think anyone could have anticipated what's taking place in the auction-rate market," Hamilton said. "There isn't a major issuer out there who isn't having heartburn right now."

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