Affordable Housing Finance

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Capital Markets Outlook 2009

Staying on the Sidelines

AFFORDABLE HOUSING FINANCE • November 2008

Experts expect bond market to settle back down soon

BY LIZ ENOCHS

Although interest rates on variable-rate debt more than quadrupled in September as credit markets seized up, those in the market for taxexempt multifamily housing bonds expect rates to settle down in the coming months.

There’s no consensus on exactly when rates will return to normal levels, but that’s one of the first things that needs to happen for demand to revive for tax-exempt bonds, according to industry participants.

“Right now, no bond deals can get done,” says Paul Sween, a principal with Dominium, a Minneapolis-based affordable housing developer and manager. With more than $200 million in seven-day variable-rate debt, Dominium has taken a hit from skyrocketing interest rates, which jumped from 1.8 percent in mid- September to 7.96 percent two weeks later. However, Sween is optimistic. “I’ve got to believe that in a matter of weeks, that money will flood into [the multifamily bond market], recognizing that risk premiums are all out of whack,” he says.

The market was virtually deserted in September, notes Jean Everett, a partner and public finance specialist at the law firm of Hiscock & Barclay. “The only issuances we’re aware of are those where they couldn’t wait it out, they had no choice.”

As of press time, most of Everett’s clients were counting on federal lawmakers to adopt a bailout plan before they’d be willing to dip their toes back into the taxexempt bond waters. “I think that things will return to relatively normal conditions even three months out,” she says. “It’s just a question of people getting their confidence restored.”

When money market funds “broke the buck” during the mid-September turmoil that led to a restructuring of the U.S. financial system within 10 days, the bond market—especially the market for shortterm bonds—was thrown into chaos. Money market funds, which were the biggest buyers of tax-exempt variable-rate demand bonds, were no longer interested in investing in those bonds. Several had failed to maintain assets of $1 for every $1 invested and were facing a run.

“You had a situation where these funds were not only not buying anything new, but they were also selling everything they had as fast as they could so they could create liquidity,” says Wade Norris, a principal with Eichner & Norris, a Washington, D.C.-based law firm that specializes in tax-exempt bond finance. After Lehman Brothers declared bankruptcy, panicked investors rushed to withdraw cash from money market funds that had investments in Lehman Brothers commercial paper, and the funds needed as much liquidity as possible to meet those redemptions.

“Right now the market, or demand, for those deals seems to be just almost frozen,” says Jay Helfrich, an Alliant Capital executive vice president, who heads the affordable debt-financing division.

One of his clients saw its variable-rate tax-exempt bonds, which are creditenhanced by Fannie Mae, get remarketed from 1.95 percent Sept. 10 to 6.25 percent a week later, and 8.25 percent Sept. 24. “The limited supply of investors with the capital to buy these bonds are able to price the rate higher and higher,” Helfrich says.

Still, few in the industry believe that such elevated rates can persist for an extended period of time. That expectation was supported by a decline in the Securities Industry and Financial Markets Association’s (SIFMA) Municipal Swap Index, the benchmark used in resetting rates on variable-rate demand bonds. It fell to 5.74 percent Oct. 1.

Another indication that market participants expect the spike in interest rates to be short-lived is the price of caps, according to Norris, who asked a broker in late September what the price would be on a five-year interest-rate cap for a multifamily deal. The answer? Between 40 and 50 basis points, up from 15 to 20 basis points a couple of weeks earlier.

That minimal cap price jump of roughly 30 basis points indicates that the counterparties to the contracts “certainly don’t think SIFMA is going to be up around 7.96 percent for very long, or that cap would cost a whole lot more,” says Norris. But he expects the global credit contraction to continue for another eight to 18 months. “As a result, I think we will have continuing gradual increases in rates on the debt side of deals, whether it’s fixedrate or variable,” Norris says.

However, he emphasizes, “It’s important for everyone in our affordable housing business to remember that this is a financial problem; this is not a problem in supply and demand for the underlying asset.”

Even so, keeping an eye on the markets is crucial, according to Everett. “It’s important for affordable housing developers to have either a good financial adviser or, on their own, a very good understanding of the capital markets, and derivative products, and what affects interest rates,” she says, as the markets are “fairly complex and becoming more complex every day.”

—with additional reporting from Jerry Ascierto