Friday, March 21, 2008

A Bonding Experience

During yesterday's Board of Trustees meeting at the Mayflower Hotel in Washington DC, Graham finally addressed the question of Penn State's variable rate bonds which I had raised earlier in the year. As is typical of the man, he wasn't completely forthcoming, but this time out he did say enough to give me a starting point for digging a little deeper in to the situation.

Here's what Graham had to say. (I've added the links.)
Next I want to address the variable rate debt issue.

The Chronicle of Higher Education recently reported that institutions carrying high variable rate debt loads have been struggling with higher interest payments on these types of bond issues.[The newspaper stories on which the Chronicle's blog post is based are here and here.] This is a very serious situation, and one that our Corporate Controller’s staff has been analyzing along with our financial adviser, Public Financial Management, and one of our lead underwriters, Lehman Brothers.

Based on this analysis, I want to assure you that we have confidence that Penn State will be largely unaffected by this issue.

First, 76 percent of Penn State’s outstanding debt is fixed rate; the remainder are Variable Rate Demand Bonds, not the auction rate bonds that have been the source of the well publicized problems. None of Penn State’s debt is affected by the current crisis, and according to Lehman Brothers, the market for Variable Rate Demand Bonds "has continued to receive record amounts of investment cash and is functioning well."

Although there is clearly some uncommon volatility even in the Variable Rate Demand Bonds markets, we continue to have attractive interest rates compared to the auction rate bonds that recently have been selling at interest rates in the mid-teens or higher.

Further, there has been publicity about the downgrades, or anticipated downgrades of bond insurers; Penn State will not be impacted by this concern because our Variable Rate Demand Bonds are not insured.

In short, Penn State is well positioned to withstand much of the turmoil in the municipal market. We will continue to keep a close eye on this issue and keep you informed of any new developments.
Before I look at what he did say, I want to examine what he didn't say.
  1. He didn't give a dollar amount on the outstanding debt the University currently holds;
  2. He didn't give a dollar amount on the outstanding variable rate debt the University holds;
  3. And he didn't specify the current interest rate on the variable rate debt the University holds.
The numbers as of the end of the last fiscal year are in the University's audit. At that time, Penn State had $175,000,000 in variable rate bonds which were paying a 3.71%. For the record, here is how these bonds are described in the audit.
Series of 2002 and Series A of 2001 – general obligation bonds issued in May 2002 for the purpose of funding a portion of the costs of the acquisition, construction, equipping, renovation and improvement of certain facilities of the University and April 2001 for the purpose of funding various construction projects, respectively. The bonds are currently paying interest on a variable rate basis; however, the University has the option to convert to another variable rate or to a fixed rate basis (such rates are generally determined on a market basis). The bonds currently pay interest at 3.71% with adjustment on a weekly basis to the rate the remarketing agent believes will cause the bonds to have a market value equal to the principal amount up to a maximum of 12%. The bondholders have the right to tender bonds at interest rate reset dates. The University, therefore, entered into standby bond purchase agreements with banks to provide liquidity in case of tender. The principal amount of the Series of 2002 bonds is due March 2032; and the principal amount of the Series A of 2001 is due April 2031 The bonds are not subject to sinking fund redemption; however, the University has the option to redeem the bonds prior to their scheduled maturity.

What we have learned about these bonds from Graham is that they are a variety called a Variable Rate Demand Bond which are also call Variable Rate Demand Obligations. I've been looking around the Web since Graham's remarks were published yesterday trying to better understand what these instruments are all about. Here is one of the better explanations I found.

The whole thing about insurance, which Graham spoke of, concerns the guarantee of liquidity. If many bond holders choose to put, i.e. sell back, their bonds at one time and the reseller can't resell the bonds, then the guaranteer of liquidity steps in and buys the bonds. The guaranteer in the case of the VRDO can be either an insurer or a commercial bank via a letter o credit, of which there are two types, the direct pay and the standby. From the audit we see that Penn State uses a standby letter of credit.

The credit rating on these bonds derives from that of the bank or insurer.

The reason that Graham emphasized that Penn State bonds aren't insured is that the problem with variable rate bonds which we have recently seen in the capital markets is due to doubts about the financial strength of some of the bond insurers. These doubts caused bondholder so sell back their bonds out of fear of having their money locked up and new buyers have not materialized out of the same fear. This drives up the interest rate of the bonds in ordered attract new buyers.

From what I have read, people currently don't see the same problem with commercial banks as they do with the insurers. This is the reason that VRDO which are guaranteed by a letter of credit from a commercial bank aren't experiencing skyrocketing interest rates. That of course could change. But to get a better handle on Penn State's exposure, we need to know the bank that issued the letter of credit.

While Graham doesn't say the underwriter of the Penn State's VRDO is Lehman Brothers, he does mention that Lehman Brothers is one of the University's lead underwriters. I'm not an expert on these matter. Is it possible that Lehman Brothers is also the bank which issued the letter of credit? If so, Penn State may be in for a wild ride, because shortly after the fall of Bear Stearns it was widely rumored that Lehman Brothers was next. The Fed stepping into rescue Bear Stearns and their opening the discount window to investment banks appears to have circumvented the problem with Lehman Brothers, at least in the short term. But, if for no reason than Lehmans involvement with the University,I think Penn State's financial situation really is something that the press should keep a very close eye on.

Finally, if any of my readers have a background in finance please correct me where I am wrong and give us your prospective in comments.

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