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Credit Crisis Adds Millions to D.C.'s Interest Payments

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By David Cho and Tomoeh Murakami Tse
Washington Post Staff Writers
Monday, April 7, 2008

Just as subprime mortgage borrowers were teased into taking out loans they later could not afford when the interest rates spiked, scores of municipalities, schools, hospitals and even museums are now facing soaring interest payments on unconventional bonds that proved too good to be true.

The District has begun paying an extra $1.2 million every month because its interest payments have doubled, and in some cases even tripled, on $601 million of these bonds. That represents nearly one-seventh of the city's total debt and includes $24 million for the Washington Nationals' new stadium, the District's treasurer said. City officials were convinced by investment banks that these types of loans would be safe and cheaper than traditional borrowing.

But the market where these bonds, called auction-rate securities, are bought and sold has collapsed, a victim of the wider credit crisis set off by the meltdown of subprime home loans. That has left public bodies, including some in Maryland and Virginia, facing dramatically higher interest payments.

Many of those affected are small bodies, but even prominent institutions -- such as Georgetown University, Carnegie Hall, and the Port Authority of New York and New Jersey -- have felt the impact. The surge in the cost of these bonds is the primary way taxpayers are being burdened by Wall Street's credit meltdown.

"This has effected a lot of issuers across the country; we are by no means unique," said Lasana K. Mack, the District's treasurer. "In hindsight, it's easy to say what we could have, would have, should have done. Nobody expected . . . the auction-rate market would go into a tailspin."

Auction-rate securities are variable-rate bonds that are repeatedly put up for bid, as often as once a week, to determine their interest rate. Normally, the bidding process produces a lower rate than that of traditional municipal bonds. But over the past few months, as the credit crisis spread across the financial system, bidders have been unwilling to buy these bonds except at high rates.

Upper Chesapeake Health System, the largest hospital system in Harford County, north of Baltimore, last year converted all of its $178 million debt into auction-rate securities to save money but instead saw its interest rates jump from 3.6 percent to 9 percent in February. Rates rose nearly 50 percent at the University System of Maryland, and at Johns Hopkins Medicine, they nearly quadrupled to 15 percent after not enough investors bid for its bonds.

Not everyone believed the sales pitch on these securities. Auction-rate bonds were shunned by all of the localities that border the District as well as the state governments of Maryland and Virginia.

"There were a lot of jurisdictions and universities that thought auction-rate securities were a slam-dunk way to lower their cost of borrowing money, and they never thought those chickens would come home to roost," said Mark Jinks, Alexandria's finance chief. "For us, there always seemed to be more risks than what appeared on the surface."

The District began converting its debt into auction-rate securities in 2001 after officials were approached by investment banks. For a time, these bonds provided some savings. But the city recently saw rates on some of its stadium bonds soar from 4.75 percent to 14 percent in a day. Among its bonds for capital improvements, rates went as high as 10 percent.

Mack said his staff has been trying to finance out of its auction-rate bonds since February. He said he hoped this could happen as early as next month, but lining up new financing is a complicated process that could take longer.

"It's presented some challenges to us," he said. "But we are taking actions to address the issue and we think we'll be able to resolve them without any major problems to the District."

For years, a wide spectrum of industries relied on auction-rate securities, including mutual funds, student lenders, schools, museums, and local and state governments. The market accounts for an estimated $330 billion worth of debt.

The growing popularity of auction-rate securities during this decade was part of a broader trend of municipalities experimenting with a variety of unconventional bonds in an effort to lower the cost of borrowing. These securities were creations of Wall Street, which earned lucrative fees for brokering such deals.

Besides auction-rate bonds, another type of unconventional security, called a credit default swap, became popular. This allows a municipality to swap its variable interest rate on its debt for a fixed rate. The District has $600 million worth of swaps. Maryland and Virginia have none.

Swaps have not caused trouble for the city so far, Mack said. But elsewhere in the country, they are causing problems. Alabama's largest county, Jefferson, is considering bankruptcy largely because it cannot come up with the money it owes under its swap contracts. It also is facing higher interest payments on its large holdings of auction-rate securities.

For years, municipalities regarded swaps and auction-rate securities as safe. If auction-rate securities failed to find bidders, the large banks that ran the auctions would step in and buy the unwanted debt.

But after Wall Street absorbed massive losses from trading in mortgage-backed bonds, these firms stopped committing their own money. The move spooked investors and the market for auction-rate securities froze at the beginning of this year. By February, hundreds of auctions were failing to get enough bidders on some days. By contrast, from 1984 until the end of 2007, 44 auctions failed, according to Bloomberg. When an auction fails, the rate resets to a predetermined level.

Loyola College in Baltimore has had failed auctions for six consecutive weeks for $43 million of its debt, raising its interest rate and costing the school an extra $600,000 a year.

Before getting into auction-rate securities, college officials pored over the history of these bonds and found few failed auctions. "We were very pleased at being able to get into this instrument," said John A. Palmucci, vice president for finance. "Everyone saw this as being a fairly liquid market."

Now the college is so anxious to get out that it is considering issuing new conventional bonds, though these would still have relatively high interest rates.

Upper Chesapeake Health has not had a failed auction, but its rates have increased. The hospital system is paying an additional $150,000 to $160,000 a week to finance its debt, said Joe Hoffman, the system's chief financial officer.

"I don't think anyone anticipated the number of failed auctions and the turmoil that it created and how that drove up rates for everybody," said Hoffman, who estimates the securities will cost an extra $2 million to $3 million in additional interest expense.


© 2008 The Washington Post Company

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