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Credit crisis seeps into bond auctions

Every week, billions of dollars in variable-rate municipal bonds are offered at auction, where they usually attract lots of institutional investors who need quick access to their money.

Every week, billions of dollars in variable-rate municipal bonds are offered at auction, where they usually attract lots of institutional investors who need quick access to their money.

But that market went haywire this week, forcing huge increases in short-term interest rates for some large borrowers such as the Delaware River Port Authority.

The problem is that bond insurers who back tax-exempt debt are losing their top credit ratings because of their exposure to complicated securities backed by subprime mortgages.

Those downgrades are causing many buyers of so-called auction-rate securities - for which interest rates are set weekly or monthly - to stay away, either because they are allowed to own only top-rated securities or they cannot risk being stuck with something they cannot sell.

This disruption, the latest in the credit markets spawned by the subprime-mortgage meltdown, is causing major headaches for government and nonprofit borrowers who used short-term credit markets to save money on the long-term cost of borrowing money to pay for such things as bridge maintenance, hospital expansion, and the construction of university laboratories.

The DRPA, with $358 million in auction-rate securities, has been hard hit.

A regular auction of $71.64 million of that debt failed Wednesday, raising the interest the authority must pay from 4.7 percent to 12 percent. That means the weekly interest expense goes from $61,000 to $164,000, John Hanson, the agency's chief financial officer, said yesterday.

Hanson said the DRPA started preparing for problems in the auction-rate market six or seven weeks ago, before the rating of its bond insurer, Ambac Assurance Corp., was cut from "AAA," but did not expect the market to deteriorate so far. "We didn't expect our auctions to fail," he said.

"Today we're scrambling to try and figure out what our options are and to work with people we have a relationship with," Hanson said, referring to investment banks and large commercial banks.

The face value of all outstanding U.S. auction-rate securities is $246 billion, according to Thomson Financial. That is nearly 10 percent of the $2.57 trillion overall tax-free municipal-debt market.

Typical buyers of auction-rate securities are institutional investors, wealthy individuals, and corporate cash managers, who want some yield but cannot tie up cash for long periods of time.

The weekly and monthly auctions give such investors the opportunity to cash in frequently.

But those frequent sales now have government, hospital and university borrowers sweating, worried about what their interest rate will be after the next auction.

The auctions are all-or-nothing affairs; if there are no buyers for all the available bonds, none of the bonds are sold. After such failed auctions, the borrower's interest rates climb to a predetermined level, often into double digits. That is what happened to the DRPA on Wednesday.

The Pennsylvania Intergovernmental Cooperation Authority has not yet had any failed auctions for its $85 million in outstanding auction-rate securities, but it has seen its interest rate climb from about 4.5 percent in December to 6.25 percent last week and 8 percent Wednesday, said acting executive director Uri Z. Monson.

Rob Dubow, Philadelphia's finance director, said his office was anxious about $199 million in auction-rate securities that go up for bid next week. The city is looking at its options, "trying to understand what makes the best sense for us," he said.

Underwood-Memorial Hospital in Woodbury, which has $63 million in auction-rate securities from 2004, has seen its interest rate climb from 4 percent to 6 percent, said the hospital's chief financial officer, James R. Brant.

A $557 million refinancing by the University of Pennsylvania Health System in 2005 included $196 million of auction-rate bonds that reset weekly, according to Ambac, which insured $337 million of the bonds.

The remainder of the bonds were insured by Financial Guaranty Insurance Co., according to the university's 2004-05 financial report. Like Ambac, Financial Guaranty has been downgraded.

University of Pennsylvania spokesman Ron Ozio declined to comment.

Getting out of the auction-rate securities is difficult for borrowers, said securities lawyers, bankers and borrowers.

PNC Financial Services Group, for example, has received hundreds of requests from borrowers seeking a bank letter of credit to supplement or replace bond insurance and a guarantee that the bank will buy back securities if there is too little demand, said George Whitmer, senior vice president for PNC's public finance and health care group.

PNC is deliberating how to help out in about 50 cases where there is no bond insurance to complicate matters or the borrower has the means to refund current creditors, Whitmer said.

James S. Lawlor, a lawyer with ReedSmith L.L.P. in Philadelphia, said there was a conflict in using letters of credit and bond insurance on the bonds.

What has to be determined is, who has the upper hand - the bank or the bond insurer - if there is a default, said Lawlor, who represents banks in current negotiations over replacing auction-rate securities with another form of short-term debt backed by a letter of credit.

Dianne Meyer, at Duane Morris L.L.P., this week completed one of the few deals amid the current turmoil in which a bank letter of credit was used to back bond insurance and get the borrower out of the auction-rate market.

The deal was extraordinarily complicated, but "the cost savings was amazing," she said. The interest rate went down 5 percentage points, she said.