Let’s be clear: the City of Los Angeles, along with many other “sophisticated” municipal issuers, played a game with the yield curve, lost and is now suing bond insurers and investment bankers in two separate actions. The City claims that it was forced to buy bond insurance and as a result of bond insurer downgrades, the City had to pay millions of dollars more than “expected” in interest on its Auction Rate securities
The City chose to issue variable rate auction bonds instead of standard fixed rate bonds.
That decision is essentially no different than a home buyer deciding to finance a purchase with a variable rate mortgage instead of a fixed rate mortgage. Maybe the City’s elected and finance officials were just uninformed yokels who where sold a bill of goods by Wall Street sharpies as the law suits suggest, but I don’t think so. Is the City’s action a display of unbelievable nerve or just California dreaming?
The City, and other municipalities, took a risk and lost. There is no free lunch, not even in California. Here is how it works. The City issues long term bonds with a 20 or 30 year final maturity. The going long term interest rate for the City, on its own credit, is let’s say 4.5% at the time of issuance. At that same time short term (6 month) rates are 2.5%. The City decides to issue variable auction bonds to capture the lower short term rate by agreeing to have the interest rate changed every 3 or 6 months through operation of recurring auction. Insurance is secured to buttress the probability of a successful auction process. It’s magic, the City gets a short term interest rate on a long term borrowing as long as short term rates say low and there is a demand for the securities at the auctions.
The City agreed in the financing documents to pay a much higher interest rate on the bonds if, for any reason, the auction failed, i.e. no bidders, which is what has happened. The higher (penalty) interest rate goes to the bond holder whose bonds did not re-price or sell as the result of the failed auction. He or she now holds the equivalent of a long term bond. The penalty rate is higher than the rate the City could have locked in if it sold uninsured regular fixed rate bonds in the first place.
Auction rate bonds are structured securities and relatively new having replaced variable rate demand bonds [VRDB], the former standard, which worked the same way but included a bank take out commitment in the event an action failed. That structure would include a fee to the bank for protection but that would reduce the short/long arbitrage spread the City hoped to gain. What’s next is Los Angles going to sue their investment bankers for not requiring them to secure a bank take out?