California Bonds Fail on Advice Bill Lockyer Couldn’t Refuse
By Michael B. Marois for cities and states to a 42-year low, as
December 17, 2009 measured by the Bond Buyer’s index of 20-year
general obligation bonds.
Familiarity Over Price
Dec. 17 (Bloomberg) — For California Treasurer
Bill Lockyer, the offer from Goldman Sachs California, with a bigger economy than
Group Inc., JPMorgan Chase & Co. and Russia’s, seeks bids for everything from build-
Citigroup Inc. was too good to refuse. ing roads and schools to buying portable toilets
and fire extinguishers. When the state with the
If California was willing to forgo competi- worst credit rating sells municipal bonds, it
tive bidding for a $4.5 billion bond offering, the usually chooses bankers through a negotiation
banks promised more orders from individuals process that lets experience and familiarity
and a lower bill to the taxpayers. The firms in- trump price.
sisted that by negotiating with them, the state
would benefit from its special relationship with For the October deal, state Treasurer Lock-
the Wall Street troika and wind up with what yer picked the world’s most profitable invest-
two underwriters called a salutary “buzz” to ment bank and the nation’s two biggest bond
boost demand for the debt. underwriters, which together have sold $31 bil-
lion of debt for California since he took office in
When the October offering failed to sell as
2007. The U.S. municipal bond market’s largest
planned, California was forced to accept 8 per-
borrower has sold tax-backed debt nine times
cent less money than it needed and to pay as
this year, for a total of about $37 billion, more
much as $123 million more in interest than the
than four times second-place New York’s total,
banks said was sufficient for the market. And
data compiled by Bloomberg show.
the threesome made $12.4 million on the deal,
contributing to record bonuses in the securities ‘Conflicts’
industry a year after getting a total of $80 billion The state’s former public finance director,
in a federal bailout. Juan Fernandez, worked on the sale as
“Just because someone earns a big wad of JPMorgan’s executive director in San Francisco.
money doesn’t mean that they can do what they Goldman’s bankers included Kathleen Brown,
say they can do,” said Marilyn Cohen, who a former state treasurer. She’s the daughter of
watched the sale unfold from Los Angeles as one past governor, Pat Brown, and the sister of
president of Envision Capital Management, another, current Attorney General Jerry Brown.
which oversees $250 million in bonds for indi- “The whole business is full of conflicts, and
viduals. “And shame on the state if they were that’s a gigantic problem,” Cohen said.
drinking that Kool-Aid.” Goldman, JPMorgan and Citigroup de-
The California sale helped send the munici- clined to comment, as did Fernandez. Kathleen
pal-bond market to its worst month in a year. It Brown didn’t respond to phone and e-mail
ended a rally that had pushed borrowing costs messages.
The $2.8 trillion market for state and local require advance marketing that banks will de-
government bonds used to be more competi- liver only if they are hired beforehand, he said.
tive. In 1970, 73 percent of municipal offerings “We have saved taxpayers a boatload of
were sold at auctions, the General Accounting money through negotiated bond sales,”
Office said in a 1983 report. In such deals, the Dresslar said, citing an analysis in the winter
bank that offers the lowest interest cost via the 2008 issue of the Municipal Finance Journal that
highest bid, or price, buys the securities and was funded by the Securities Industry and Fi-
tries to sell them for more. nancial Markets Association.
This year, 16 percent of $368 billion in new The authors concluded that competitive
fixed-rate issues were sold that way, Bloomberg sales have “no general advantage” and criti-
data show. The rest were negotiated offerings, cized past studies that found interest costs on
in which underwriters are selected before the negotiated sales were as much as 70 basis
sale based on assurances they’ll deliver cheaper points, or 0.7 percentage point, higher.
rates by lining up investors.
True Interest Cost
California’s estimate of the so-called true
When the New York banks’ promises to interest cost on the tax-exempt portion of the
California proved unreliable, Lockyer, 68, not October sale indicates it spent more the last
his underwriters, tried to explain the miscalcu- time it sold competitively.
lation to taxpayers.
Including fees, the $1.3 billion negotiated
“It turned into a bad week for bonds,” the sale cost 33 basis points less than the national
treasurer said in an Oct. 9 interview. “This average for 20-year general- obligation bonds
seemed to be a very hard week with some head- at the time, excluding a risk premium of almost
winds for issuers.” 1 percentage point the state paid after ap-
The underwriters left Lockyer “standing on proaching insolvency, Bloomberg data show.
the platform alone,” said Christopher Taylor, When the state sold $1.1 billion in tax- free secu-
former executive director of the Municipal Se- rities at auction on Feb. 14, 2007, the cost was 13
curities Rulemaking Board in Alexandria, Vir- basis points over the average.
ginia, a self-regulatory organization. Taxpayers “Even though they couldn’t sell as much as
“probably didn’t get their money’s worth be- they wanted, and even though they sold at
cause California only got someone taking or- yields at higher levels than what they wanted,”
ders,” he said. “They didn’t get somebody out the deal “went well from California’s point of
there that had any really strong incentive to view,” said Gary Pollack, who oversees $12 bil-
sell.” lion as head of fixed-income trading at Deut-
Banks don’t want “any unsold bonds hang- sche Bank AG’s Private Wealth Management
ing around,” so they prefer to help states set unit in New York. “They were able to borrow
rates and see if the bonds sell, as happens in ne- $4.1 billion at relatively historically low yields.”
gotiated deals, Taylor said. If demand falls After the sale, several states scaled back
short, the dealers say, “Listen, we can’t sell this” borrowing plans as municipal bond yields
without higher yields, he said. “It’s a wonderful climbed the most in two weeks since December.
world that the dealer community has created —
just fees, no risk.” ‘Litmus Test’
Saving a ‘Boatload’ Maryland sold $200 million of debt on Oct.
21, about 25 percent of what it had wanted to
Lockyer has no regrets about using a no-bid offer, Bloomberg data show. Minnesota issued
process because an auction would have led to $576 million of bonds, or 64 percent of its
even higher interest costs, said Tom Dresslar, planned total. Hawaii and Washington took
his spokesman. While auctions may be effective similar steps after rising yields erased projected
for smaller issues, multibillion-dollar sales of savings from refinancing.
both taxable and tax-exempt bonds like this one
“California’s large offering proved to be a competitive one, a memo obtained through
litmus test for investors’ tolerance for new sup- California’s Public Records Act shows. In past
ply at relatively low yields,” said Chris Holmes, auctions, winning underwriters couldn’t line
a fixed-income strategist at JPMorgan in New up enough buyers ahead of time, so “they bear
York, in a note to clients after the sale. It “set a more risk and the price they are willing to pay
tepid tone for subsequent large offerings by the state for the bonds will likely be lower,” in-
other issuers,” he said. creasing taxpayers’ interest costs, the New
Municipal yields rose almost half a percent- York firm wrote.
age point from their 3.94 percent low following If the consultant “had not recommended a
the sale and were a quarter- point above that negotiated sale, had they recommended a com-
mark as of Dec. 10, the weekly Bond Buyer in- petitive sale to get the best deal for taxpayers,
dex shows. that’s what we would have done,” said
Unemployment Dresslar, the treasurer’s spokesman.
California is strapped for cash amid the Taylor, the former MSRB official, said fi-
worst global recession since World War II. The nancial advisers rarely recommend auctions.
most-populous state’s personal income tax ‘Blackballed’
revenue fell 33.4 percent in the second quarter, “The FA has no incentive to irritate the un-
compared with a 27.5 percent national average, derwriter community by pushing the risk on
according to the Nelson A. Rockefeller Insti- them,” he said. “Any FA that pushes a competi-
tute of Government in Albany, New York. tive sale is going to get ‘blackballed.’”
Unemployment in California was 12.5 percent
Lockyer’s staff advised him on Aug. 24 to
in October, the worst since at least 1976. Nation-
hire Goldman and JPMorgan to manage a $3.2
wide joblessness was 10.2 percent in October, a
billion mix of taxable debt, including federally
26-year high, and 10 percent in November.
subsidized Build America Bonds, and
The October sale was California’s first Citigroup to lead the simultaneous sale $1.3 bil-
long-term debt offering since Republican Gov- lion of tax-exempt securities.
ernor Arnold Schwarzenegger and the Demo-
cratic Legislature settled a three-month impasse Goldman, which accepted $10 billion in
over how to erase a $24 billion deficit in July. bailout money last year and repaid it eight
months later, produced a $3.44 billion profit in
The stalemate, which put the state on the the second quarter, a record for a U.S. invest-
brink of insolvency for the second time this ment bank. Its shares have almost doubled this
year, ended with the approval of an $85 billion year. JPMorgan, which has repaid its $25 billion
budget. California has cut spending by $32 bil- bailout, is this year’s top U.S. bond underwriter,
lion, raised taxes by $12.5 billion and papered according to Bloomberg data that excludes mu-
over $6 billion in shortages with borrowing and nicipal issues. Its shares are up 31 percent.
what Pacific Investment Management Co.’s Bill
JPMorgan’s investment bank and
Gross has called “accounting tricks that
Goldman will set aside an unprecedented $32.1
couldn’t fool a grade-schooler.”
billion for compensation this year, according to
Imminent Downgrade an estimate by David Trone, a Macquarie Secu-
The July compromise prompted credit-rat- rities Group analyst. That will produce record
ing companies to remove California from lists of bonuses totaling $19.3 billion, based on New
borrowers facing imminent downgrades. The York pay consultant Options Group’s estimate
state’s general obligation bonds are graded BBB that year-end awards usually account for 60
by Fitch Ratings, Baa1 by Moody’s Investors percent of compensation costs.
Service and A by Standard & Poor’s. ‘Lowest Borrowing Costs’
Public Resources Advisory Group, a finan- Second-ranked underwriter Citigroup is re-
cial consultant for the state since 1991, recom- paying $20 billion of its $45 billion bailout to es-
mended a negotiated sale instead of a
cape U.S. Treasury Department- imposed pay forehand because they don’t know if they’ll
restrictions as the government prepares to sell its “have the bonds to sell,” Mukai said. Under-
remaining stake in the company to recover the writers in negotiated offerings “market the
rest. The shares are down 49 percent this year. state’s transaction for at least a week in ad-
The three banks were told by California in vance,” his letter said. “As a result of these ef-
Sept. 21 engagement letters that they were ex- forts, Citi and the other underwriters will
pected to “perform at the highest level to assist acquire accurate information as to the depth of
this office in achieving a successful sale at the buying interest, which is invaluable in the pric-
lowest borrowing costs.” The sales syndicate ing of the issue and in securing the lowest pos-
also included Bank of America Corp.’s Merrill sible borrowing costs.”
Lynch & Co., Siebert Brandford Shank & Co., Mukai reminded Lockyer that Citigroup
Wells Fargo & Co. and about 30 other banks and had helped JPMorgan sell September’s
brokers that made $13.4 million on the deal, for short-term debt to individuals, “saving the
a total of $25.8 million in fees. state millions of dollars,” and had imple-
Before selling the long-term bonds, Lock- mented California’s “Enhanced Retail Market-
yer shored up the state’s finances by borrowing ing Plan” in June 2007.
$8.8 billion through one-year cash-flow notes, a “We believe all the retail marketing efforts
routine move used to pay expenses while await- in these past few negotiated sales have
ing anticipated tax revenue. achieved tremendous success for the state,”
Record Demand leading to more than $8.1 billion in general-ob-
ligation bond sales to individuals, or 46 percent
That Sept. 23 offering, run by JPMorgan, at- of new issues, Mukai wrote.
tracted twice as much demand from individual
investors as from mutual funds and other insti- ‘Buzz’ Memo
tutions. So-called retail orders totaling $6.64 bil- Goldman and JPMorgan offered Lockyer
lion, about 75 percent of the sale, was the most similar assurances in a joint Oct. 6 memo outlin-
ever for a municipal issue, Lockyer’s office said, ing how they would help draft an offering doc-
citing underwriters’ data. ument, design a sales presentation and perform
California paid as much as 1.5 percent on the “pre-marketing and price-discovery activities”
debt, more than twice New Jersey’s cost for simi- to help structure the issue at the cheapest yield.
lar securities in August. The yield was in the low “This process will generate a ‘buzz’ around
range of what had been advertised beforehand, the transaction, ultimately generating maxi-
and individual demand allowed the state to turn mum investor participation in the sale, which
away $430 million in orders from institutions. we believe will translate into lower borrowing
“Investors clearly know a good deal when costs,” wrote Tim Romer, a Goldman manag-
they see one, and California taxpayers will benefit ing director in Los Angeles, and JPMorgan’s
as a result,” Lockyer said after the sale. Fernandez, who had been the state’s finance di-
rector from 2002 to 2006.
That same day, Citigroup told Lockyer that
the state would get a “vigorous pre-sale market- The two firms “strongly believe that pro-
ing effort” to “the broadest possible audience of ceeding with a negotiated sale” of the bonds
potential investors” and “greater retail participa- “will result in a more cost- effective sale than a
tion” for October’s long-term debt sale if he competitively bid transaction,” they wrote.
agreed to a negotiated deal, according to a letter Lowest Since ‘67
from Chris Mukai, a director for the bank in Los Investors, including Envision Capital’s Co-
Angeles. hen, predicted the October sale would go well,
‘Very Little Incentive’ given the popularity of Build America Bonds,
When banks have to bid for bonds, they securities created by President Barack Obama’s
“have very little incentive” to find investors be- economic stimulus package, which covers 35
percent of their interest costs.
As of Oct. 1, state and local governments Deputy Treasurer Katie Carroll and Public
had sold at least $36.9 billion of the debt, about Finance Director Blake Fowler flew to New
14 percent of year-to-date borrowing. The York to monitor the sale, accompanied by
bonds attracted buyers to the municipal market Dresslar.
and reduced tax-exempt supply, helping drive Fowler, 43, has spent most of his career in
down average yields to 3.94 percent, the lowest municipal bonds. A year ago, Carroll, 53, gave a
since 1967, from 4.92 percent on April 2, the talk on “ways to maximize demand” from indi-
Bond Buyer’s index shows. viduals to the National Association of State
“There seems to be a voracious appetite for Treasurers. Then in Fowler’s job, Carroll em-
the BABs bonds no matter who the issuer is,” phasized the value of advertising on radio and
Cohen said in an interview the day before the giving retail buyers a two-day “priority pe-
sale. As for the $1.3 billion tax-exempt portion, riod” for placing orders.
“they should have a relatively easy time selling Day One
it because it’s not so huge,” she said.
The bankers went into the sale telling in-
Increasing Supply vestors California would pay tax-exempt yields
In the weeks before the bond sale, Lock- from 2.87 percent for the 2015 maturity to 4.63
yer’s staff watched yields slide as state and local percent for bonds due in 2029. The 20-year was
authorities kept issuing more debt to lock in low 23 basis points lower than indicated at the time
rates. Borrowers were benefiting from the re- by a Bloomberg index designed to gauge the
covery following the financial meltdown that fair value of similar bonds. The estimate for
had spurred a rush to the perceived safety of yields on taxable securities available to individ-
Treasuries after the collapse of Lehman uals ranged from 3.5 percent to 3.75 percent.
Brothers Holdings Inc. a year earlier. On Oct. 6, the first day of retail sales, the
About $270 billion in new municipal bonds three California officials sat in a conference
had been issued from Jan. 1 to early October, 16 room in Barclays Capital’s New York head-
percent more than at that point in 2008. Califor- quarters on Seventh Avenue. As they talked to
nia’s 2009 tax-backed bond and note sales to- credit-rating companies about another bond is-
taled $23.4 billion by Sept. 30, up from $4.6 sue, they monitored orders for the current one,
billion and $10.6 billion in the first three quar- which the London-based bank helped sell.
ters of 2008 and 2007, respectively. They phoned in updates to Lockyer. With
Demand might wane “because we are at Municipal Market Advisors data showing
lows in terms of absolute yield levels,” said yields already starting to rise, individuals
Peter Hayes, who oversees $106 billion in mu- bought 28 percent of the tax-exempt bonds and
nicipal bonds for BlackRock Inc., on Oct. 6. 25 percent of the taxable debt, less than half the
California officials said they knew the demand seen on the first day of the September
bonds would be a harder sell than the Septem- sale.
ber notes. To keep debt payments low, Lockyer The underwriters “told us before the deal
loaded the tax-exempt portion with maturities not to expect the level of retail that we had been
longer than what individual investors typically getting,” Dresslar said. By the time of the sale,
buy. they painted an even gloomier picture of con-
‘We Got Spoiled’ cessions that investors wanted “to get the deal
done at least close to the size” California
“We are so used to getting 50 percent, wanted, he said. “Some of the numbers that
60-plus percent, 80 percent retail,” said were coming out were startling.”
Dresslar, the Lockyer spokesman, referring to
how much individuals bought of an offering. Day Two
“We got spoiled,” he said. “We were fully cog- The following morning, the three officials
nizant that this was not going to be a walk in the and their financial advisers were ushered into a
park.” conference room in Goldman’s 85 Broad St.
headquarters. Fueled by coffee, pastries and extra interest would total $123.5 million, data
sandwiches over a 10-hour day, they decided to compiled by Bloomberg show.
raise yields by as much as 4 basis points on “It’s justified for Cal to be paying a little
tax-exempt bonds to attract more orders. higher price in order to sell its debt, given its
The market’s response “may reflect some credit issues,” Deutsche Bank’s Pollack said in
anxieties with the retail investors in buying any- an interview that day. “Their budget was not as
thing that’s longer” than one- year notes, Lock- tight and strong as I think a lot of people would
yer said on Bloomberg Television that day. “It have liked it to be.”
may be pricing. It’s hard to tell.” The sale’s biggest maturity, $1.75 billion of
By the end of the second day, retail buyers 30-year Build America Bonds, was priced to
had placed orders for $427.7 million, or 33 per- yield 7.23 percent, 95 basis points more than
cent, of the $1.31 billion tax-exempt portion and comparable corporate bonds and 325 basis
$77.5 million of the $250 million of taxable points more than Treasuries with similar matu-
bonds available to individuals. All together, re- rities. With the subsidy, California’s net cost is
tail sales amounted to 11 percent of the $4.5 bil- about 4.7 percent. Ten-year Burlington North-
lion the state wanted to borrow. ern Santa Fe Corp. bonds with the same
Day Three Moody’s ratings as California traded at 122 ba-
sis points more than Treasuries that same week.
The next morning, the California officials
moved to Citigroup’s offices to finish the offer- ‘Best Shot’
ing with sales to pension plans, hedge funds, “They just got a little aggressive in where
nonprofit groups and other professional buy- they wanted to price it,” said David Blair, a
ers. Pimco analyst in Newport Beach, California,
“We’re depending on the institutional in- the day after the sale. “Most people still recog-
vestors to make this work,” Lockyer had said on nize that there’s budget deficits the state is try-
TV. ing to deal with,” said Blair, whose company
oversees $20 billion in municipal bonds.
In a room off the trading floor, the officials
decided to cut the sale to $4.14 billion — $1.31 Lockyer’s spokesman portrayed the sale as
billion in tax-exempts, $1.75 billion in Build a success.
America Bonds and $1.07 billion in other tax- “To say that the market conditions were
able bonds. not as favorable as they had been doesn’t mean
They also increased some yields again as that you go in conceding hundreds of millions
institutions grew more wary of the state’s fi- of dollars; you go in and give it your best shot
nances. Tax-exempt rates ended up 8 to 37 basis because there’s a lot at stake,” Dresslar said.
points higher than estimated, including the “Given the cold market and the inhospita-
20-year, which was boosted to 5 percent from ble attitude of investors, to pull off a $4.1 billion
4.66 percent. Debt due in 2025 went to 4.69 per- deal, we believe, is an impressive achieve-
cent from 4.42 percent. Four taxable issues, in- ment,” Dresslar said. “We would have been
cluding the Build America Bonds, cost the state derelict in our duty to taxpayers if we sold a
12.5 to 25 basis points more than the low end of bond of this size through a competitive sale. We
estimated ranges. Two priced at the high end, would have gotten hosed.”
and two were above it. Highest Rate
Extra Interest By Oct. 15, 20-year yields had risen 0.38
The yields, averaging almost a quar- percentage point to 4.32 percent from its previ-
ter-point more than estimated, will result in ous low, the biggest two-week increase in 10
California paying $8.1 million a year more in in- months, the Bond Buyer index shows. Califor-
terest than it would have at the lower rates. If nia has since sold $7.3 billion in debt. On Oct.
the bonds all are outstanding at maturity, the 22, it paid 8.361 percent on $250 million of
lower-rated Build America Bonds — then the Lockyer has said the state may issue more
highest coupon rate for a $100 million-plus is- debt before the fiscal year ends on June 30 with-
sue since the program began. out specifying how much.
A week later, the state was able to cut esti- “Everybody thinks there’s still an appetite
mated yields as much as 0.15 percentage point for California bonds,” the treasurer said in the
on $3.5 billion in better-rated tax-exempt bonds Oct. 9 interview. “If the market is inhospitable,
when individuals placed orders for almost 72 we won’t go,” he said. “We’ll just have to wait
percent, including debt due in 2022 that cost the and see how the feelings are when we get ready
state 4.85 percent, up from 4.47 percent in the to think about it again.”
early October sale. Tom Dalpiaz, who helps Advisors Asset
California sold $908 million in Build Amer- Management oversee $3.3 billion in Melville,
ica Bonds on Nov. 3, pricing the 30-year securi- New York, said California and its bankers had
ties to yield 7.26 percent, or 3 percentage points flooded a glutted municipal bond market with
more than Treasuries, down from October’s too much supply.
3.25-point spread. The sale gave investors “sticker-shock syn-
drome,” said Dalpiaz. “It was a very large bond
issue to digest.”