Innovations in variable-rate financing for local governments in Florida.
Editor's note: Each year the Government Finance Officers Association bestows its prestigious Award for Excellence to recognize outstanding contributions in the field of government finance. The awards stress practical documented work that offers leadership to the profession and promotes improved public finance. This article describes the 1994 winning entry in the policies and procedures subcategory of the capital financing and debt administration category.
The Sunshine State Governmental Financing Commission (the "commission") created in November 1985, through interlocal agreements between the Cities of Orlando and Tallahassee, was established to enable a limited number of Florida's governmental units with similar credit worthiness and high investment grade credit ratings to benefit from the economies of scale associated with large financings and to assist them in the development and structuring of financial programs and activities.
The commission consists of a representative of each participating local government. Commission members elect a board of directors from among the appointed representatives to administer the approved programs. There are no employees of the commission. The organization's staffing is provided by member representatives or by contracting for certain professional activities. Commission costs are borne by the borrowers, based upon the size of their outstanding loan.
In structuring the issuance of its bonds and local government loan program, the commission established the following goals and objectives.
* To provide local governments with the opportunity to finance capital projects at the most favorable short-term variable rates available in the tax-exempt market.
* To reduce overhead costs by sharing fixed issuance expenses, such as those for bond counsel, financial advisor, remarketing agents and administration.
* To make available an additional financing alternative which local governments may consider when entering the credit markets.
* To provide a secure, credit-enhanced program without cross indemnification by one participant for the principal and interest obligations of other participants.
* To simplify the process of raising capital by allowing participants to secure funds without the cost and time associated with arranging individual tax-exempt financing.
* To provide local governments access to the variable rate markets when individually the borrowings might not be of sufficient size to access these markets.
The Variable-rate Program
In July 1986, the commission sold $300 million of variable-rate put revenue bonds. In November 1986, the proceeds were made available for loans to qualified units of local government to finance or refinance capital projects. Within 18 months of issuance of the bonds, nearly all of the proceeds were fully committed. The participants in the original program were the Cities of Tallahassee, Orlando, Miami, Coral Gables and Vero Beach, as well as Dade County, Palm Beach County and Polk County. All of this 1986 issue is still outstanding.
In 1992, as the commission began development of a second variable-rate program, it examined the various financing instruments available to fund its programs. It determined that commercial paper was the lowest cost alternative and provided the most flexibility in increasing or decreasing the amount of debt outstanding. There were several problems, however, that would need to be addressed before the commission could meet all of its goals.
The most significant problem was finding a low-cost credit enhancer and liquidity provider. Historically, both of these functions had been met through a letter of credit (LOC) issued by a major money center bank with a AA or AAA credit rating. Due to the decline in the number of providers, the cost for an LOC on a pooled program had escalated to between .5 percent and 1 percent annually. In late 1993's low interest rate environment for tax-exempt commercial paper (2 percent to 3 percent), the additional cost of an LOC made the rate to the borrower generally noncompetitive with other short-term fixed rate alternatives.
The commission sought to separate the liquidity provider from the credit enhancer and, in so doing, expand the universe of potential liquidity and credit providers. Through a competitive process, the commission selected an insurance company to provide credit support (bond insurance). Liquidity support was provided through a commercial paper future purchase contract with the State of Florida, State Board of Administration. The commission believes this is the first time a public pension plan has been used to provide liquidity support for a variable-rate commercial paper program.
The up-front borrowing costs, which reimburse the commission for the cost incurred in the design and implementation of the program prior to originating loans, are 25 basis points plus the cost of bond insurance. A borrower's monthly charges, in addition to its proportionate share of the commercial paper interest expense, will range from 25 to 32 basis points, depending upon the dollar amount of loans outstanding. These fees pay for remarketing, trustees, auditing, liquidity, rating agency and other administrative costs.
The commission believes the program was very well received and met all of its objectives. The market has recognized and accepted this alternative form of liquidity support by establishing yields on the commercial paper competitive with a AAA-rated bank's LOC. With very little marketing activities, the commission has received loan applications, if approved by the insurer, totaling approximately $150 million. The flexibility to convert a participant's loan at any time from a variable rate to a fixed rate without purchasing additional bond insurance, together with the low cost and ease of access, is the reason for the high level of governmental interest. Discussion of some of the problems and solutions relating to credit enhancement and liquidity provision are presented in the remainder of this article.
Liquidity from State Pension Plan
Tax-exempt commercial paper generally requires a liquidity provider to assure the holder of the paper that, in the event the remarketing agent is unable to remarket the paper, the liquidity provider will step forward and guarantee payment at maturity. Liquidity support has traditionally been provided by large money market and international banks with short-term credit ratings of A-1/P-1/F-1 or better. Pool financings generally have purchased an LOC providing both credit and liquidity support. A limited number of pooled variable-rate financings have used bond insurance for credit enhancement and a bank line of credit for liquidity.
As the number of money market or international banks with high quality credit ratings sufficient to provide either a line or letter of credit for this program has shrunk, the annual costs for such a credit enhancement has risen appreciably. Today, these fees generally range from 5/8 percent to 1 percent per year. With interest rates falling and letter-of-credit fees increasing, the cost of LOC fees, when added to interest on the commercial paper, made the pooled commercial paper program less competitive with other more traditional, short-term financing options.
Banks traditionally are compensated via a stand-by fee for agreeing to issue their lines or letters of credit in advance of when they are actually needed. The commission, however, wanted to create a program whereby current and future members could access this source of financing when needed, with no current obligation on participants to borrow nor on the commission to incur ongoing costs not borne by a borrower. It needed a liquidity provider that was willing to charge only for the amount of liquidity facility actually used with no fees for the unused portion of the commitment.
The problem facing the commission was to develop an alternative to traditional liquidity/credit support facilities that was significantly lower in cost. The solution was to find a provider that was currently a large investor who, as a normal part of its business, purchased and owned a large portfolio of commercial paper. The commission saw a potential solution in the asset base of a large pension portfolio--the State of Florida pension portfolio managed by the State Board of Administration (SBA).
The SBA manages the $30 billion state pension fund, a $10 billion local government surplus fund investment account that is invested in money market instruments and $5 billion in other trust funds. The daily cash flow and liquidity in a portfolio of this size was more than adequate to provide liquidity for the commission's $150 million commercial paper program. By unconditionally contracting to purchase the commission's commercial paper in the event of a failure, the SBA could create additional income for the portfolio and provide the state an opportunity to assist local governments without incurring costs. Minimal ongoing administrative costs would be incurred once the program was established. Additionally, the SBA could be guaranteed minimal risk on a return competitive with other taxable alternatives in the unlikely event that it had to purchase the securities.
There were hurdles that had to be overcome before the commission and SBA could enter into such agreement:
* getting the SBA rated by the rating agencies,
* assuring the SBA that it would never be a long-term holder of the paper and
* finding a bond insurance company that was willing to assist the commission in developing a nontraditional variable-rate blind pool program.
The commission and the SBA, working together, solved the first problem. The SBA applied for and received an A-1+/F-1+ rating from Standard & Poor's and Fitch Investors Service, respectively.
The SBA's strong preference not to hold the paper for a period greater than one year irrespective of the interest rate being paid was addressed in two ways. First, the agreement provided that when the SBA bought the commercial paper, it would initially be at a rate competitive with other taxable commercial paper rates, but the rate would periodically step up over the course of a year the longer the SBA was required to hold the paper. This would provide the borrower a very strong economic incentive to convert its loan to a fixed rate; the only logical reason it would not do so would be because the financial condition of the government precluded it from issuing fixed-rate debt.
The solution was to have a bond insurer agree that in the event the borrower choose to fix its loan, the premium paid on the variable-rate program would be applied to the fixed-rate program. This guaranteed that the borrower, irrespective of any deterioration in its credit quality while the loan was outstanding, could convert to fixed rate at then-current interest rates with bond insurance already in place. Thus, there should be no impediments to a borrower converting its commercial paper to a fixed-rate issue and retiring the commercial paper held by the SBA.
Since the SBA would be purchasing securities for local governments' investment trust funds, state funds or the state's pension funds, the basic concern was that there would be virtually no credit risk involved. The program was designed to provide the SBA with a double barrel protection with: 1) an underlying credit rated A or better related to the participant (city or county) government and 2) a AAA credit provided by the bond insurer. The combination was seen as eliminating any credit concerns that otherwise might be associated with the commercial paper holding. SBA's concerns regarding potential initial or recurring administrative impact on the SBA were met by the commission, as the pooling agent, agreeing to take on both the cost and the obligation of any ongoing administration burden that might otherwise be placed on a liquidity provider.
The parties agreed that the commission would pay the SBA 10 basis points on a daily weighted average amount of commercial paper outstanding on a quarterly in-arrears basis. The initial program allocation of capacity was not to exceed $150 million; thus, when the program was fully operational, the SBA would expect to receive $150,000 per year to provide this forward commitment contract. The 10-basis-point fee for liquidity was seen as both attractive to the commission and as reasonable and fair to the SBA; this lower cost was possible because the SBA is not subject to the reserve requirements placed on the banking industry that cause those liquidity providers to charge higher fees.
The third hurdle that had to be surmounted before the commission and SBA could complete an agreement was to find a bond insurer that was willing to work with the commission in navigating around the pitfalls of negotiations with the various parties and write a nontraditional bond insurance policy. Since bond insurance generally is issued to secure a fixed-rate financing, a traditional bond insurance policy would not have worked using a nontraditional liquidity provider such as the SBA. In response to a request for proposal to most of the major insurers, only one indicated a high level of interest and demonstrated the flexibility to meet the commission's and SBA's needs. This insurer's willingness to work with the commission in developing the program and working around the particular needs of the SBA was critical to the success of the program.
There were two basic questions to be resolved with the insurer concerning the structure of the bond insurance: 1) What type of credit should be insured? and 2) What would be the nature of the insurer's commitment? The commission desired that the primary pledge provided by the participants be a covenant to budget and appropriate from non-ad-valorem revenues subordinate to essential services. The insurer indicated its willingness to consider this approach with the understanding that some of the potential participants may not be acceptable using this credit; and thus, participants may be required to pledge 1) a specific revenue stream or 2) a covenant to budget and appropriate combined with a specific revenue pledge (either as requested by the participant or required by the insurer). The commission traditionally limited its targeted participants to those holding an A or better credit rating and anticipated that most would qualify to utilize a covenant pledge under this program.
A separate problem related to how the insurance commitment would apply initially to a variable-rate loan but continue to apply if the borrower converted from a variable-rate financing to a fixed rate. The solution was to have the bond insurance to guarantee a market for the fixed-rate loan; the loans, not the commercial paper, would be insured. Since the amount of commercial paper always will equal the amount of loans outstanding and all loans are guaranteed by the insurer, the rating agencies were willing to give the commercial paper program their highest rating.
Bond insurance typically is priced as a basis-point quote on total debt service; pricing insurance for variable-rate financings, however, is more complex. The commission's insurer agreed to allow each borrower the opportunity once during the life of the loan to recapture all or a portion of the interest paid for, but not used, through a reamortization of its loan. Illustrating the process is an example of an initial 10-year loan of $10 million with an interest rate assumption of 9.2 percent. The interest rate during the first five years will average 4.6 percent. At the end of five years, the borrower converts from variable to fixed rate at 6 percent. The borrower could extend the term of the loan for the remaining five years by approximately another five years without the payment of any additional insurance premium.
The maximum fixed maturity of any loan, including the reamortization, may not exceed 25 years. No amortization of principal is required during the first five years, and the amortization of principal thereafter is determined by the borrower subject to approval by the insurer. Additional limitations on reamortization also are applied by the insurer.
The insurer agreed that the debt service reserve fund required for a fixed rate bond issue would not be required during the commercial paper period and allowed participants to pay the premium (related to the principal and interest of the debt service reserve fund) at the time of conversion. Other special provisions relating to debt service reserves were provided in the insurance agreements.
Concepts, Costs and Benefits
This new commercial paper program advances two major concepts. This is the first time a state's pension fund has been used as a liquidity facility for a broad-based local government borrowing program. This has the potential of providing a major new source of capital to the market, adding diversity to a market where there are fewer and fewer high-quality liquidity providers. It provides a new source of additional revenue to pension plans without exposing the plan to much additional credit risk. The program provides a vehicle for states or other large governmental units to assist other units of local governments with marginal ongoing effort after the initial development of the program and approval of the basic documents.
The second innovation is that the bond insurance is on a loan that initially may be in a variable-rate (commercial paper) mode and subsequently can be converted to fixed rate. The borrower does not lose the insurance because of this conversion process and, therefore, have to purchase additional insurance. The insurance assures the liquidity provider that there will be a market for borrowing fixed-rate debt in the event that the commercial paper cannot be remarketed.
The commission appropriated $250,000 to develop the program and prepare all documents. The development cost is estimated at $200,000 for a $150 million program. The program can be expanded beyond $150 million by amendment to the bond purchase agreement at no incremental cost. The development cost as a percent of the current program is .13 percent, which is judged to be reasonable in light of the complexity of the program.
The benefits to the commission, even with this developmental cost, are still very significant. The annual savings in liquidity fees is estimated to be between .3 percent and .5 percent. On a $150 million program, this results in annual savings to borrowers of $450,000 to $750,000 per year and additional income to the state of $150,000. Lastly, most letters or lines of credit are for five years or less. There is no guarantee that a current liquidity provider will renew the letter or line at the end of the commitment period or at what costs. This program potentially eliminates or minimizes such renewal risk.
It is probably easiest to measure a product by the market reception it receives. Having completed the initial loan in February 1994, the commission now has received participant requests and applications from seven governments totaling approximately $150 million.
The ease, flexibility and cost advantages to the prospective participant are such that the program is almost self-marketing. The effort required of a finance officer, when compared to a traditional financing, is minimal: there is no official statement to publish or contracts to negotiate, and most of the review by the bond insurer can be from copies of budgets and published comprehensive annual financial reports. With 30 to 45 days of application, a borrower can have proceeds in hand. There is no call feature to limit flexibility, and a borrower concerned about increasing interest rates can buy a swap or cap to limit the volatility of debt service associated with variable-rate financings.
The commission believes that other governmental units may find these concepts and solutions potentially beneficial and useful. Expansion of the market of liquidity providers should put downward pressure on prices and, thus, benefit those using a traditional LOC provider, while some of the bond insurance concepts may have broader application than just variable-rate financings.
The developmental cost of duplicating the program for other governments should be significantly less than the commission's expenses. Much of the cost was incurred in developing and negotiating the basic documents. Duplicating the program could probably be done at about one-half of the commission's cost.
ROBERT B. INZER, treasurer/clerk for the City of Tallahassee, Florida, is a former member of the GFOA Executive Board and currently represents the public sector and issuers as a member of the Municipal Securities Rulemaking Board. G. MICHAEL MILLER is the director of finance for the City of Orlando, Florida, and a member of GFOA's Committee on Accounting, Auditing and Financial Reporting. Readers interested in obtaining more information about the Sunshine State Governmental Financing Commission and the variable-rate borrowing program should contact Inzer at 904/891-8130 or Miller at 407/246-2341.
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|Title Annotation:||Award for Excellence|
|Author:||Inzer, Robert B.; Miller, G. Michael|
|Publication:||Government Finance Review|
|Date:||Oct 1, 1994|
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