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Shaky bond insurers cost taxpayers money 

Wednesday, Aug 13 2008

Sage editors, wishing to impress upon cub reporters that nothing is news unless it's extraordinary, repeat a journalism adage: We never write about the planes landing on time. We wait until they crash.

Notwithstanding, I'll use this space to report on $1.2 billion of airport bonds, among other things, that haven't yet landed in a figurative fiery crash that could end up costing local taxpayers millions of dollars.

But thanks to apparent bumbling during the past few months by city-employed airport finance officials, there exists unnecessary risk that some of these bonds just might end up that way. And that risk could have been foreseen.

Surrounding SFO's maladroit financial engineering lies an extraordinary story most newspaper readers don't know about, but should: It's a financial domino effect set in motion by defaulted home loans in California's Central Valley and across America. It involves reverberations from a recent meltdown in the market for a certain type of adjustable-interest-rate municipal bonds. The turmoil was so unexpected, massive, and widespread that it is draining what could amount to hundreds of millions of dollars from the budgets of government or nonprofit agencies that have borrowed money by issuing what once was a type of relatively inexpensive debt.

The story of this nationwide financial crisis has been told only in the financial press. And even then, reporters haven't examined what it means for taxpayers, consumers, patients, and charity donors. The fallout from this mess will be constrained state and local government budgets, potentially higher bridge tolls, less money for university financial aid, and shortfalls at agencies that provide water, electricity, and irrigation.

Some critics cry fraud. Lawsuits in Los Angeles and Connecticut accuse bond rating agencies and bond insurance companies of peddling faulty information and worthless products.

This is a story that involves heroes — unsung officials at tiny institutions such as private colleges who negotiated tough-minded bond deals to protect themselves from greater losses. It also has its zeros, such as the SFO officials who replaced bonds that had been expensively undermined by troubled insurers with — get this — new bonds that also happen to be covered by another troubled insurer.

In between are hundreds of agencies kept financially sound by staff burning the midnight oil. For the Bay Area Toll Authority, an agency set up to pay for the retrofit of the Antioch, Benicia-Martinez, Carquinez, Dumbarton, Richmond-San Rafael, San Francisco-Oakland Bay, and San Mateo-Hayward bridges, this crisis has affected some $800 million in debt. According to an agency memo, some $200 million that would have been available for new projects won't be immediately available because of the refinancing required. "Was this expensive? Yes, it was," BATA spokesman Randy Rentschler said. "Are we unhappy about this? Yes. Did our finance staff keep very busy for many months? Yes. Are our financing plans okay afterwards? For us, the answer is also yes.

"For others," he added, "I am not so sure they are okay."

The current troubles stem from a Feb. 12 collapse in the market for a special type of municipal bond whose interest rate rises and falls with market conditions, similar to the way homeowners see changes in their adjustable-rate mortgages. Though these are characterized as municipal bonds, governments also issue billions of dollars in this kind of debt on behalf of public-service-oriented nonprofits such as the University of San Francisco and hospitals like Kaiser Permanente.

To make the bonds supposedly foolproof for investors and thus carry low interest rates, issuers such as the city of San Francisco bought bond insurance from highly rated companies such as Ambac Assurance Corporation. But early this year, debt ratings agencies such as Moody's took a closer look at such companies and decided they weren't such a good risk after all. It turned out the insurers had unwisely taken on a new line of business: a trillion or so dollars in all-but-worthless mortgage-backed securities.

The insurance companies' likelihood of making good on policies was "downgraded." As a result, interest rates paid on these variable-rate bonds (also known as auction-rate bonds) didn't merely vary — this spring they exploded. For some bond issuers, rates doubled; others more than quadrupled after insurance policies that guaranteed bonds' repayment became all but worthless.

State and local governments along with nonprofits like USF have had to buy back and reissue billions of dollars' worth of bonds to stop paying the high interest rates.

Yet there has been no public tally of these total costs. Public finance involves trillions of dollars in public money and tens of billions in profits for bankers, lawyers, brokers, lobbyists, and other consultants, yet its practitioners are shielded by unusual opacity and lack of public accountability.

None of the experts I talked to say public agencies shouldn't have taken out a portion of their debt in the form of variable-rate bonds. Just like stock investors, bond issuers are advised to balance a portfolio of stable and riskier financial instruments.

But it so happens each bond issue is an individual contract filled with pages of fine print. In the case of the bonds in question, some of those tiny sentences describe ballooning interest rates in the event of a market meltdown — once upon a time seen as unlikely.

That fine print is where the heroes and zeros are made.

The Port Authority of New York and New Jersey negotiated variable-rate bond deals that ended up allowing interest rates to recently rise as high as 20 percent.

Nadia Sesay, director of the San Francisco Mayor's Office of Public Finance, is arguably one of the heroes of this story. She appears to have kept the city relatively unscathed in a couple of instances. On $264 million in debt issued to finance the construction of Moscone Center West and Laguna Honda Hospital, the city never saw interest rates go higher than 7 percent, and is now spending some $1.2 million to reissue new fixed-interest debt with a rate below 5 percent.

San Francisco's biggest bond market problem, however, is at the airport, where more than $1.2 billion in debt was reissued following the spring interest rate explosion. Airport officials refused to say how much this cost the city, but records obtained from regulators suggest officials may have been careless in protecting taxpayers from further risk. In attempting to smooth over its problem, the airport issued new variable-rate bonds covered by insurance from a company called Financial Security Assurance. But just two weeks after the airport issued these bonds May 1, Moody's said it would reassess the company's ratings after to worse-than-expected losses on mortgage bonds. Moody's will decide in September whether to downgrade Financial Security Assurance's credit rating. If it does, San Francisco will again be exposed to potentially millions of dollars in additional costs.


It isn't just giant airports affected by this market crisis. The California Treasurer's Office provided me with a list of 95 state agencies that have issued some $28 billion of auction-rate securities since 2000. That's only a fraction of debt affected by the meltdown. The treasurer's office told me it has no accounting of the total in California of variable-rate municipal bonds of the type issued by San Francisco.

Indeed, this crisis is so widespread and insidious that if you're a consumer, taxpayer, student, commuter, or patient, you're likely to be affected.

The San Francisco-based hospital chain Catholic Healthcare West, for example, recently obtained state approval to reissue some $2.2 billion in affected bonds. Stanford Hospitals and Clinics has been authorized to reissue $665 million. The East Bay Municipal Utilities District has issued more than half a billion dollars in affected bonds; the city of Gilroy, $45 million.

Another typical group of victims: students at USF. Reverberations from the February market meltdown have meant the university is paying hundreds of thousands of dollars more per year in expenses on its debt — about what it would cost to give 10 freshmen full-ride scholarships. "It's $400,000 less a year we'll spend on other things that are more important," says vice president for business and finance Charles Cross.

Like other global financial crises, this one has critics crying for investigations. Lawsuits in Connecticut and Los Angeles allege a Wall Street conspiracy to defraud issuers of municipal bonds. If these allegations are true, a full accounting could mean billions of dollars returned to the public's pockets.

If blundering public investment managers are bad for a bond issuer's financial health, colluding Wall Street hustlers are worse. E-mails recently released in connection with the Connecticut lawsuit suggest a conspiracy between ratings agencies and insurers to fraudulently compel municipalities to buy worthless insurance. According to the lawsuit complaints, ratings agencies falsely assigned weak credit ratings to cities while giving the highest possible rating to companies insuring hundreds of billions of dollars in mortgage-backed junk bonds. The result was unnecessarily high interest payments siphoned to investors from governments and nonprofits, and millions of dollars spent on faulty insurance policies.

A spokesman for Oakland's city attorney told me the office plans to file a similar lawsuit. "We're monitoring the cases closely," said Matt Dorsey, spokesman for San Francisco City Attorney Dennis Herrera, adding that there's no decision yet on whether San Francisco might follow Oakland's lead.

It seems apparent in hindsight that it was wrong to tell investors that cities such as San Francisco, host to the Pacific Rim's financial services industry, was more likely to default on its obligations than junk bond insurers.

If these cases are deemed to have merit, the list of potential plaintiffs could be pages long.

About The Author

Matt Smith


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