February was a bad month for Stephanie Doughty, the chief financial officer for Poudre Valley Health System, as interest rates on most of its $215 million in auction-rate bonds climbed steeply, adding as much as $140,000 to weekly interest costs. Posted on 03/09/2008 1:03:23 AM PST by TigerLikesRooster
Bond debt rates surge
The auction-rate bond market has collapsed, with Colorado hit hard.
By Aldo Svaldi and Jeffrey Leib
The Denver Post
Article Last Updated: 03/08/2008 03:54:45 PM MST
February was a bad month for Stephanie Doughty, the chief financial officer for Poudre Valley Health System, as interest rates on most of its $215 million in auction-rate bonds climbed steeply, adding as much as $140,000 to weekly interest costs.
On Monday, things are expected to get worse when $50 million of that debt goes to auction to face higher rates.
"It was just unbelievable, to see such a dramatic change in a debt vehicle that has been so sure for 20 years," Doughty said. "We said what can we do to remedy this as quickly as possible."
Poudre Valley, which operates hospitals in northern Colorado, is one of 14 Colorado institutions facing sharply higher interest rates because of the collapse of the auction-rate bond market.
The market's failure — there have been no buyers at hundreds of bond auctions — is fallout from the subprime mortgage crisis and huge losses posted by Wall Street investment banks.
"This is a 25-year-old market, worth $350 billion. Who would have thought," said Kirsten Volpi, chief financial officer at the Colorado School of Mines, which had $43 million in auction-rate bonds.
Denver International Airport, Children's Hospital, the CollegeInvest Student Loan program and the E-470 toll road are among the other institutions slammed by higher interest payments.
In all, $4 billion in bonds in Colorado are at risk and if the issuers do not get out of the failed market, they face paying an extra $103 million a year in interest compared with what they paid last fall, according to a Denver Post estimate.
The auction-rate bond market started failing on a large scale four weeks ago, forcing financial executives to scramble to convert or refund their debt.
The School of Mines already has refunded its auction-rate bonds, and DIA is moving out of about $750 million in similar debt.
"The whole industry is looking to convert out of auction-rate securities," said Leonard Dryer, chief financial officer for Children's Hospital. "No one believes the auction-rate market will settle itself back down."
Children's has $325 million in auction-rate bonds, sold in 2004 and 2006 to build its new campus in Aurora.
These institutions used auction- rate bonds for the same reason homeowners picked 1-year adjustable-rate mortgages instead of 30-year mortgages — short-term interest rates, while they can fluctuate, are usually lower.
"Financing long-term assets with short-term borrowing is at the heart of the problem," said Christopher Johns, manager of the Tax Free Fund of Colorado, which avoided the bonds.
For years, the market worked, saving issuers large amounts of interest as the price of the debt reset at auction every seven, 28 or 35 days.
Buyers came to consider the securities as safe as holding cash.
The Colorado institutions also bought bond default insurance, which gave the debt a triple-A rating.
The Wall Street investment banks, which arranged the marketing of the bonds, served as a buyer of last resort if no other investors bid in the auctions.
From 1984 to 2007, only 44 auctions failed, according to Bloomberg News.
But the subprime mortgage crisis, where high-risk mortgages were packaged and widely sold as securities, rocked even this once-stable market.
Bond insurers, such as MBIA Inc. and Ambac Financial Group, who guaranteed Colorado bonds, also branched into insuring mortgage securities.
As losses on mortgage securities mounted, the credit ratings of bond insurers came under pressure, raising doubts about the protection the insurers could really offer.
Investment banks supporting the auctions also ran into trouble because of their investments in mortgage- backed securities.
The world's largest banks have written off more than $181 billion in bad mortgage-related investments, leaving them less able financially to step in and support the auctions.
"Wall Street is not in a position to take that debt on their balance sheet," said Ken Harris, a co-manager of the Westcore Colorado Tax Exempt Fund.
Auction-rate bonds suddenly lost their luster and liquidity.
In February, thousands of bond auctions, including those of Colorado institutions, failed as no investors or banks bid on the bonds.
Such a "failed auction" triggers payment by the bond issuer of a maximum interest rate — often as high as 12 to 15 percent — to holders of the bonds.
Auction-rate municipal bonds now have higher yields than government treasuries — even though they are tax-exempt. This rarely happens.
"When you see short-term muni rates spike up because of the penalty rates, it carries through the rest of the market," Johns said.
Higher rates have brought out some buyers who see little risk of defaults on the bonds.
"We never participated in the auction-rate markets over the last 20 years," said Westcore's Harris. Now, his fund is loading up on auction-rate bonds.
New buyers helped bring down rates from maximum levels, but issuers aren't expecting interest rates to return to where they were last fall.
One of the hardest-hit issuers in Colorado is the E-470 toll road, which in June converted $422.1 million of fixed-rate debt to auction-rate bonds.
Interest rates on those bonds soared from an October low of 3.5 percent to a February high of 11.95 percent.
On Thursday, E-470 experienced its first failed auction, and the interest rate hit the 12 percent maximum.
The soaring rates mean the toll highway authority faces a $24.43 million increase in annual interest costs if it stays in the auction-rate market. It is looking at ways to exit the market.
"We never expected the market would go completely dysfunctional," said John McCuskey, E-470's finance chief.
E-470, he said, has reserves and a "rainy day" account to cover the short-term impact of sharply higher interest rates.
In Colorado Springs, Memorial Health System saw two failed bond auctions in mid-February drive rates from the 3 percent range to the maximum rate of 12 percent.
Memorial Health, which operates city hospitals, sold about $272 million in auction-rate bonds in 2002 and 2004 for hospital expansion.
More recently, the hospital's bond interest rates dropped to between 9 and 6.5 percent as some investors came back into the market.
Still, chief financial officer Gary Flansburg said, if the interest rate stays at 6.5 percent, Memorial Health will pay an extra $800,000 a month on its debt. At 10 percent, the extra monthly tab would be $1.6 million.
"We're working as diligently as we can to transfer these bonds to a different mode," he said.
Student aid provider CollegeInvest is Colorado's largest issuer, with $980.4 million of its $1.6 billion debt in auction-rate bonds.
The student-loan lender is paying $1.8 million more in interest each month than it did last summer, said spokeswoman Jennifer Robinson.
If sustained, those higher interest rates could ripple through to higher costs on some types of adjustable-rate student loans, something the student aid provider is trying to avoid, Robinson said.
Meanwhile, Poudre Valley Health System — which operates Poudre Valley Hospital in Fort Collins and the Medical Center of the Rockies in Loveland — awaits Monday's bond auction.
It issued $215 million in bonds in 2005 primarily to build the Loveland facility.
The bonds are rebid every 35 days and until recently were paying at auction an average of about 3.37 percent interest, said Poudre Valley's Doughty.
Then, on Feb. 19, with auctions failing all over the country, investors bid up the price on $82 million of the Poudre debt to 10.55 percent, suddenly loading the hospital system with an extra $140,000 in weekly interest.
The system so far has paid the the extra interest costs out of cash reserves and has not reduced staff or otherwise cut operations, Doughty said.
The hospital system, however, will restructure the debt. Going to fixed-rate bonds will probably add about $2 million in annual interest payments compared with $7 million if it stays with auction-rate bonds.
"Instead of paying investors the extra money," Doughty said, "we would rather have that cash available for capital equipment and other hospital needs."
Ping!
Can someone give me a quick tutoring in this. I read the article and basically understand it but I am looking for more insight. Thanks.
Yes, bond buyers are getting nice returns.
Can someone give me a quick tutoring in this. I read the article and basically understand it but I am looking for more insight. Thanks.
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With the bond insurers failing buyers are demanding a higher interest rate be paid as the income generated from the project (rather than the rating of the insuring agency) is now the primary concern when it comes to repayment..
What Denver is seeing is nothing ,, these are small increases compared to what Orlando got hit with for the three vanity projects of our mayor ,, an arts center , a new stadium for the Orlando Magic and refurbing (again) the underutilized Orange bowl stadium ,, estimated at $1B ,, we are already over by $150M just in interest expenses as buyers see this as a boondoggle (they’re right) with none of the three ever able to repay their initial cost ,, instead we are relying on tourist taxes to pay for them just as we enter a long drawn our recession to pay the bills..
bmp
Are we seeing a domino effect started by the toppling of the sub-prime mortgage lending market? Where will this one end?
States scrambling to convert action-rate bonds to fixed securities but funding sorces are in the tank on the sub-prime lending losses.
Again, where will this one end?
” Again, where will this one end? “
Hint: Start a crash study program on subsistence farming, and lay in a supply of trade goods....
This is just one line in a series of converging trends — it’s not gonna be pretty.....
Two years ago we set out to pay off our house. It will be paid off in a couple more months and we can then start buying canned goods I suppose.
where will this one end?
Look up stagflation.
Now the problem lies in the fact that your Government has taken to starting long term projects and funding them on cheap short term money (only to find out short term money is no longer cheap).
“Again, where will this one end?”
Nobody really knows. Billions of dollars that were invested in equity investments are disappearing. That sounds like deflation to me but I’m no expert.
The same Bloomberg reported a few days ago that some 70% of the auctions had failed and issuers wanted to bid at their own auctions, a thing not now allowed.
The people with ARM home mortgages have an empty bar stool waiting for financial officers.
Interest rates reflect:
* Demand for debt (the market has little appetite for debt, these days) low interest = no interest from the market
* The risk that the debt won’t be repaid.
* The waning credibility of the rating agencies and bond insurers as means of assessing and mitigating risk.
All right, who’s been talking down the Auction Rate Bond Market, people are gonna start blaming us for that too.
“Several brokerage houses tumbled; blue-sky investment companies formed during the happy bull market days went to smash, disclosing miserable tales of rascality; over a thousand banks caved in during 1930, as a result of marking down both of real estate and of securities; and in December occurred the largest bank failure in American financial history, the fall of the ill-named Bank of the United States in New York.” ~~"Only Yesterday: An Informal History of the 1920’s" by Fredrick Lewis Allen
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."~~Ludwig von Mises
"Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump."~~Ludwig von Mises
"True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression."~~Ludwig von Mises
"Credit expansion is not a nostrum to make people happy. The boom it engenders must inevitably lead to a debacle and unhappiness."~~Ludwig von Mises
"What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit boom is built on the sands of banknotes and deposits. It must collapse."~~Ludwig von Mises
"If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders."~~Ludwig von Mises
Yep, the same permabull tout Pollyanas are going to, after the fact, say, “Everything was just peachy, until the doomers started ‘talking down’ the economy.”
Try to point out a coming train wreck, and they laugh and mock you. After the train wreck, they’ll blame you for it. You brought it on by “bad karma” or something.
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