By: Daniel J. Malpezzi
Government entities and nonprofit 501(c)(3) organizations are among the most active borrowers in the tax-exempt bond markets.
Historically,
banks and other financial institutions have been involved in lending to
tax-exempt entities in several ways. One of which is by providing a
letter of credit to support variable rate demand obligations, or
"VRDOs," issued by or for the benefit of nonprofit borrowers and
governmental entities, such as counties, cities, school districts,
townships or boroughs, and sold in the capital markets by underwriters
who initially purchase the obligations. In the case of nonprofit
organizations that do not have the legal ability to directly issue
tax-exempt debt, the obligations must be issued through a conduit
authority having the power under Pennsylvania law to issue tax exempt
bonds or notes for the benefit of the intended ultimate user of the VRDO
proceeds, i.e. the "borrower." Such issuers may include general
municipal authorities, "special purpose" municipal authorities such as a
hospital or water and sewer authority, industrial development
authorities, redevelopment authorities, or one of the various state
level issuers, such as the Pennsylvania Economic Development Authority
or the Pennsylvania Higher Educational Facilities Authority.
VRDOs
represent a type of variable rate bond that is structured to provide
the benefit of allowing governmental or nonprofit organizations to
borrow money on a long term basis, but at short-term interest rates.
Such obligations typically have the following features: (i) the interest
rate is reset by an independent "remarketing agent" on a periodic
basis, usually daily, weekly or monthly; (ii) the holders of the
obligations have the right to "put" or require the issuer/obligor to
repurchase the bonds at the holder's option ("optional tender"), thus
allowing the holders to readily cash-out of their investment; (iii) the
obligations are subject to a required purchase and sale ("mandatory
tender") upon the happening of certain specified events, such as the
replacement of a supporting letter of credit, the expiration of the
letter of credit without provision of an alternate letter of credit or
at the direction of the letter of credit bank following a default by the
obligor under the governing letter of credit documents; and (iv) upon
an optional tender or mandatory tender, the remarketing agent attempts
to remarket and find new buyers of the bonds.
To make all of this work, a bank or other financial institution
issues a letter of credit in favor of the trustee or paying agent for
the VRDOs. The letter of credit provides that the trustee or paying
agent may draw upon the letter to make payments of principal and
interest on the bonds when due and to provide a source of payment of the
purchase price of VRDOs that are subject to optional or mandatory
tender and which the remarketing agent has been unable to remarket and
sell for any reason. All draws under the letter of credit must be repaid
by the borrower to the issuing bank, with interest at a bank-designated
interest rate. These arrangements have the effect of providing credit
enhancement for the VRDOs by substituting the credit and credit rating
of the letter of credit bank for the credit and credit rating of the
governmental or nonprofit conduit borrower. This structure also provides
bankruptcy preference protection to payments of the purchase price of
tendered bonds to the extent that such purchase price payments are drawn
on the letter of credit and not the borrower's own funds. A bank or
other financial institution issuing a supporting letter of credit is
effectively extending a credit facility to the borrower, which would by
documented between the letter of credit bank and the borrower by a
reimbursement or letter of credit agreement and secured by mortgages,
personalty or other collateral in the same manner as any other loan.
For
a community bank to provide such credit enhancement, however, the bank
needs to have debt that is rated in the capital markets by one of the
nationally recognized rating agencies like Standard & Poor's Ratings
Services, Moody's Investors Service or Fitch Ratings. Otherwise the
function of substituting credit ratings for the VRDOs does not work. In
the past, in order to work around this problem, smaller banks could
accommodate their customers by structuring a transaction whereby (i) a
financial institution with the requisite rating would issue a fronting
letter of credit to the VRDO trustee or paying agent and (ii) the
community bank would issue a backing letter of credit to, or otherwise
enter into a reimbursement agreement with, the fronting letter of credit
bank providing for the payment by the "backing" bank of all draws on
the fronting letter of credit. The "credit" extended by the backing bank
to its governmental or nonprofit customer would be documented and
collateralized as a loan transaction.
Such arrangements worked fairly well while letter of credit
commitment fee rates were relatively low and until the credit market
turmoil that occurred in 2007, 2008 and into 2009. During this period,
the availability of letters of credit essentially disappeared as many
letter of credit banks experienced significant draws on their credit
facilities as investors exited the VRDO market en masse. This
resulted in letter of credit banks holding a substantial exposure to
"bank bonds" which they now owned as a result of letter of credit draws
to fund the purchase price of optional tenders and for which there
existed no demand for a remarketing and sale. This liquidity issue no
longer exists for the most part, but the fallout from the turmoil is
that the bank pricing for letters of credit has significantly increased
to the point where it is difficult for a VRDO transaction to
economically justify the dual level of fees involved in the use of two
letters of credit. This is particularly true given the current
historically low fixed interest rates, and the fact that many issuers or
conduit borrowers are choosing to utilize fixed rate tax-exempt debt in
order to take advantage of the low rates and to avoid the uncertainties
and pitfalls of letter of credit backed VRDOs.
Another potential method of participating in tax-exempt lending by
community banks is through the provision by the bank of a "liquidity
facility" for VRDOs in the form of a standby bond purchase agreement
delivered to the bond trustee or paying agent for the benefit of the
VRDO issuer or conduit borrower. This is an agreement whereby the
delivering bank agrees that it will purchase VRDOs that are the subject
of an optional tender by bondholders or a mandatory tender under the
bond documents in the event the tendered bonds cannot be sold by the
remarketing agent. The bank becomes the owner of the tendered bonds,
which then typically bear interest at a much higher "bank rate" and are
subject to accelerated amortization and repayment if the bonds remains
"Bank Bonds" for a specified period of time. Unlike a letter of credit, a
standby bond purchase agreement is limited solely to the purchase of
bonds, and does not support scheduled payments of principal and
interest. However, similar to the letter of credit structure, the
delivering bank must have an adequate recognized credit rating in order
for the standby bond purchase agreement to meaningfully support and add
credit enhancement to the VRDO issue.
The good news is that even
if a bank or other financial institution does not have a formal or
adequate credit rating by S&P, Moody's or Fitch, it can still take
advantage of tax-exempt lending opportunities by making direct
tax-exempt loans to government entities or 501(c)(3) nonprofit
organizations. These kinds of loans are sometimes referred to as
"bank-qualified" or "BQ" loans. Unfortunately, but perhaps not
surprisingly, the tax law and IRS rules and regulations governing
bank-qualified loans are complex and can be difficult to understand for
financial institutions that do not regularly engage in such lending.
There
are two levels of analysis involved in looking at a potential
bank-qualified loan. The first is whether the loan can qualify for
tax-exempt treatment at all. Not every loan to a government body or a
nonprofit organization is or can be tax exempt. The use of bond/loan
proceeds and the project to be financed must all fit within one of the
qualifying categories and set of rules for tax-exempt debt under the
Internal Revenue Code and accompanying IRS regulations. The second level
of analysis is whether the loan, even if tax-exempt, can be
bank-qualified.
What does it mean for tax-exempt obligations to be bank qualified?
Under the Internal Revenue Code, financial institutions that acquire
tax-exempt bonds or notes are subject to loss of a corresponding
deduction for its interest carry expense unless the subject bonds or
notes are designated as "qualified tax-exempt obligations" under Section
265(b)(2)(B) of the Code. If so designated and qualified, a financial
institution is subject to only a 20% loss of its allocated interest
deduction, the so-called "TEFRA penalty." An issuer can only designate a
bond or note as a "qualified tax-exempt obligation" if (i) the bond or
note is not a "private activity bond" other than a qualified 501(c)(3)
bond (for example, a small issue manufacturing bond), (ii) the issuer
reasonably anticipates that it will not issue more than $10 million in
tax-exempt bonds (other than non 501(c)(3) private activity bonds) in
the calendar year in which the bond or note was issued and (iii) the
issuer did not designate more than $10 million of bonds or notes as
qualified tax-exempt obligations in that calendar year. Certain special
rules apply for purposes of aggregating related issuers, dealing with
composite issues (i.e. issues for more than one purpose, such as a
partial refunding and partial new money issue) and allowing a "deemed
designation" of certain qualifying bonds used to refund other
outstanding bank-qualified debt.
Those financial institutions
who are active in bank-qualified lending will remember that the American
Recovery and Reinvestment Act of 2009 (ARRA) had significantly expanded
these bank-qualified limitations for obligations issued in calendar
year 2009 and 2010 by (i) increasing the ceiling on the $10 million
limits described above to $30 million and (ii) allowing the conduit
501(c)(3) borrower or governmental entity (if different from the actual
issuer) to be treated as the "issuer" for purposes of the bank-qualified
rules so that the expanded $30 million limits could be measured "by
borrower" and not "by issuer." ARRA also created a safe harbor basket of
tax-exempt bonds or notes that could held by financial institutions in
an amount up to 2% of their assets having the same tax effect as
designated bank-qualified bonds. These changes greatly increased the
capacity of a single issuer to issue, and ability of financial
institutions to acquire and fund, bank-qualified tax-exempt obligations.
Regrettably, Congress failed to include in the year-end tax bill that
was signed by President Obama on December 17, 2010 an extension of these
special bank-qualified rules, including the 2% safe harbor, beyond
December 31, 2010. Consequently, tax-exempt obligations that are issued
after that date are once again subject to pre-ARRA rules and
limitations.
Community banks that desire to engage in tax-exempt
lending to government entities and nonprofit organizations can explore
the alternatives described above. While this is a highly technical area,
the demand and credit quality that many of these kinds of borrowers
present are often very attractive. This is particularly true of
government borrowers whose obligations are backed by its full faith,
credit and taxing power pursuant to a borrowing under the Pennsylvania
Local Government Unit Debt Act.
© 2011 McNees Wallace & Nurick LLC
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