CDFA Spotlight: Types of Credit Enhancement By Stan Provus

Preface

Well over 60% of tax-exempt bonds are issued with some form of credit enhancement. This article examines a few of the most common forms of credit enhancement—bond insurance and bank letters of credit. These and other credit enhancement techniques are examined in depth during CDFA's Advanced Bond Finance Course.

Credit Enhancement or Substitution

Credit enhancement refers to a bond issuer’s purchase of outside support or an issuer’s use of other sources of credit enhancement, particularly public credit enhancement programs to improve an issuer’s or conduit borrower’s credit standing. The purpose of credit enhancement is to reduce interest costs either by improving the rating or mitigating risk on a portion of a bond issue, such as getting bond insurance for a term bond only rather than the entire issue. Typical outside supports include commercial bank letters of credit, bond insurance, and guarantees, such as FHA insurance for housing issues. Public credit enhancement techniques include moral obligation pledges, intercept programs, and a number of structured state programs used by bond banks for local infrastructure and development finance agencies for business, housing, and other purposes.

The credit substitute provides protection to bondholders, even in the event of issuer default and bankruptcy. This includes conduit bond issue borrowers. Since the support is total, the debt/issue is assigned a rating reflecting the dependence on the credit enhancement provider or technique employed by an issuer. Through credit substitution, an issuer can improve the credit quality of an issue, simplify for investors the understanding of an otherwise complex security arrangement, or provide support for some portion of a financing for which an issuer’s own resources may be inadequate.

The purpose of credit enhancement is to reduce interests costs either by improving the rating or mitigating risk on a portion of a bond transaction. The Internal Revenue Code generally requires that credit enhancement, such as bond insurance and bank letters of credit, be cost effective. The cost of the credit enhancement must be less than the interest rate savings resulting from the credit enhancement on the bonds.

Types of Credit Enhancement

Private credit enhancement may be in the form of:

- Mortgage insurance,
- Bond insurance,
- Bank Letters of Credit
- Guarantees
- Senior/Subordinate Bond Structures
- Credit Enhancement from State Revolving Loan Funds and Long-Term Pools

Public credit enhancement may be in the form of:

- Moral Obligation pledges
- Full faith and credit pledges
- Pledged collateral funded from public sources, or
- Intercept Programs

Mortgage Insurance

Mortgage insurance is an agreement by a third party to insure the mortgage payments to be made by a conduit borrower to the bond trustee. For example, FHA and private mortgage insurance is used to insure mortgage payments on single and multifamily housing loans that are funded from bond proceeds. Ginnie Mae, Fannie Mae, and Freddie Mac may also guarantee multifamily mortgage loans. Among the more widely used FHA multifamily programs is Section 221(d)(3) and (4).

The federal government cannot guarantee most categories of private activity bonds—housing is the major exception.

Bond Insurance

A municipal bond insurance policy is a noncancelable guarantee designed to protect the bondholder from nonpayment on the part of the issuer. Municipal bond insurers insure about 50% of all new money bond issues. In the event the issuer fails to meet a scheduled principal or interest payment, the insurer, acting as a third-party guarantor, will make that debt service payment to the bondholder on time and in full. The bond insurer receives an upfront insurance premium for the guarantee, the amount of which is determined primarily by the perceived risk associated with the financing. Bond insurance premiums are typically charged based on a percentage, such as .2-2%, times the principal and interest paid over the life or maturity of an issue. Unlike bank letters of credit that must typically be renewed every 3-5 years, bond insurance remains in place for the entire term of the bonds. In many instances, bond insurance, if available to an issuer/conduit borrower, will be less expensive than bank letters of credit over the life of an issue.

Most bond insurers (AMBEC, MBIA, etc.), including the leading insurers, are rated “AAA”. Generally, “AAA” bond insurers will not put their insurance on issues unless the underlying issuer or conduit borrower is rated at least “BBB” or better (investment-grade or better) on a stand-alone basis. One exception to this rule is ACA (American Capital Access). ACA is an “A” rated insurer whose target market is underlying credits in the A- to BB and unrated market segments—if unrated they still look for a credit quality equivalent of BB. The AAA insurers have traditionally underserved issuers or conduit borrowers in these market segments.

Bond Insurance and LOC Differences

There are a number of structural differences between bond insurance and letters of credit (LOC), particularly in the context of insured or LOC-backed variable rate demand obligation bonds, where the interest rate is typically reset every seven days. Bond insurance extends over the life of an issue, while a LOC must be renewed; e.g. every 3-5 years. The bond insurer is obligated to pay bondholders only on regularly scheduled principal and interest payment dates and is not ordinarily obligated to make payment for accelerations due to defaults, unscheduled redemptions, or tenders of the bonds. In other words, if an issuer or conduit borrower defaults, a bond insurer will continue to make scheduled debt service payments, while LOC banks will accelerate and collapse the issue, paying the outstanding principal and interest due at the time of the default.

Another difference between bond insurance and LOC is considerations related to the interest rate savings, compared to the cost of the credit enhancement. The upfront bond insurance fee, which is based on the life of the bonds, is weighed according to how long the bonds are expected to be outstanding. LOC-backed bonds allow the issuer/conduit borrower flexibility in deciding whether to retire the bonds early, without the penalty of losing the value of an upfront insurance fee, which is based on the full life of the deal.

This cost issue is illustrated by the following example. Assume: (1) a $5 million variable rate demand obligation IDB; (2), amortized over 20years at $250,000 year; (3) a 3.85% bond interest rate, a 1% LOC fee vs. a 2% bond insurance premium. In this example, the issuer would pay an upfront bond insurance premium of $138,500 ($5M plus $1,925,000 (interest at 3.85 over the life of the issue) =$6,925,000 X .02=$138,500). Over the 20-year life of the issue, the issuer would otherwise pay LOC fees totaling $533,629. However, if the issuer elected to prepay the LOC deal in the second year, only about $100,000 would have been expended for LOC fees vs. $138,500 for a bond insured deal called in the second year. In general, however, bond insurance is going to be less expensive for most issuers than LOC fees, if it is available—many issuers or conduit borrowers will not quality for bond insurance because they are not investment grade rated or rated at all.

Bank Letters of Credit

A letter of credit (LOC) is a contractual promise by a credit provider to pay, for a certain length of time, a specified amount of money to a designated beneficiary (trustee for bondholders) upon the happening of certain specified events.

For example, many Small Issue bonds for manufacturers are sold as variable rate demand obligations (VRDO) and secured by rated bank letters of credit. Under the reimbursement agreement, a LOC provider enters into with an issuer or conduit borrower, the provider, in exchange for payment of an LOC fee (typically .5%-2% of the outstanding principal amount annually) issues a LOC payable to the bond trustee. The LOC requires that the provider (almost all are domestic or foreign banks, although GE Capital also provides AAA-rated LOCs), for the term of the LOC, to pay to the trustee an amount equal to the full principal of the issue, plus a specified amount of interest such as 40 days or more. The bond trustee will draw upon the LOC either to make all debt service payments (a “direct pay” LOC) or to cover issuer default (a “standby” LOC). The borrower must reimburse payments made by the LOC provider.

In a VRDO bond issue, a LOC is also used to provide a “liquidity facility.” VRDO bonds such as weekly low-floaters have a demand feature whereby the bondholder may require purchase of their bonds at par plus accrued interest either periodically or at will—often on 7-30 days notice to the issuer. In the event the remarketing agent cannot sell the bonds to another holder, the liquidity facility is drawn upon to purchase the put bonds.

Another type of LOC is a “Confirming” or wrap LOC. Many smaller or community banks may provide LOCs to secure bond issues. However, because these banks may not be rated by one of the three bond rating services, their LOCs are considered non-rated by money market funds and others that buy VRDO bonds. As a result, smaller banks look to “upstream” banks to provide “confirming LOCs. Rated confirming LOCs are drawn upon if the correspondent bank does not honor draws on its LOC. This type of “double-tiered structure” may also be seen with “Master” LOCs wrapping other LOCs in pooled or composite bond issues—this is done to homogenize the bond issue. The Pennsylvania Industrial Development Authority and Florida Development Finance Corporation use the composite, two-tiered LOC bond structure for qualified small issue and 501 (c)(3) borrowers.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.