On Friday, January 18, 2008, Fitch Ratings downgraded Ambac Assurance Corporation two notches to AA. There is widespread expectation in the market that Moody's and Standard & Poor's may soon do the same, although this is not a certainty. Following on our November 30, 2007 Public Finance Alert regarding the rating agencies' review of the AAA-rated bond insurers, we note that each news cycle seems to bring more bad news for several bond insurers, and the risk has risen greatly that other bond insurers thought to be "untouchable" will be downgraded by one or more rating agencies.
These ratings downgrades, which are part of the continuing fallout of the subprime mortgage debacle, may not have any immediate effect on many municipal issuers and conduit borrowers, but could affect others greatly. The effect on a specific obligor of a rating downgrade of an insurer will depend on a number of factors, including the terms of outstanding bonds (fixed or variable rate), the existence and termination provisions of insured interest rate hedges, and whether the insurer has provided investment vehicles or a debt service reserve surety policy.
- For fixed rate bonds, a rating downgrade of the insurer will not affect the interest cost of the municipal issuer or conduit borrower. However, it will likely have an adverse effect on the value of bonds insured by that insurer as they are traded in the secondary market. This may provide an opportunity to accomplish a refunding of outstanding bonds through a tender offer where an express right to redeem is not available or is available only at a much higher price.
- For variable rate bonds, the interest cost could increase at the next interest reset date. How much and how fast will depend upon a number of factors, including the severity of the downgrade, the credit rating of the issuer or conduit borrower as the underlying obligor, and the liquidity features of the bonds. Additionally, the effect on interest cost may be different for auction rate securities than for variable rate demand bonds. Variable rate demand tender bonds, which permit bondholders to "put" their bonds to a remarketing agent for purchase, may find more acceptance among investors than auction rate securities.
- For transactions on which an insurer has provided a debt service reserve surety (in lieu of funding a reserve fund with cash) or a guaranteed investment contract (for investment of a project or reserve fund), the effect of an insurer downgrade will depend on the specific terms of the bond indenture or resolution but may require liquidation of the investment contract or a substitution of the surety or cash funding of the reserve.
- For interest rate hedge transactions in which the obligations of the issuer or conduit borrower to the counterparty are insured, a substantial downgrade of the insurer could permit a counterparty to terminate the transaction, regardless of whether the issuer or conduit borrower has suffered any credit decline or defaulted in any way with respect to its obligations to the counterparty. This will depend on the specific terms of the hedge agreement that were negotiated when the transaction was executed. If the issuer or conduit borrower is "out of the money," it could be liable for a substantial termination payment solely as a consequence of the insurer's credit difficulties.
Almost without exception, the downgrade of a bond insurer by one or two notches (i.e., to AA+/Aa1 or AA/Aa2) will not, in and of itself, create an immediate default under the bond indenture, loan or lease agreement, or other bond documents, or cause any reallocation of rights or responsibilities among the parties. Insured hedge transactions will almost certainly not be affected by an insurer's downgrade unless the insurer's rating is reduced below A-/A3.
For insured bonds subject to continuing disclosure requirements, an insurer's downgrade by a rating service that rates the bonds may necessitate the filing of a "material event notice."1 With respect to guaranteed investment contracts and debt service reserve surety policies, issuers and conduit borrowers should consult counsel as to the specific terms of bond documents, the impact of a downgrade and whether a notice should be filed.
Issuers of variable rate bond issues that are supported by both bond insurance and a liquidity facility may face increased liquidity facility fees as a result of a downgrade. Additionally, depending on the terms of the individual liquidity agreement, the downgrade may permit the liquidity facility provider to terminate the facility altogether.
Issuers and conduit borrowers should review their bond documents with counsel to identify any rating-related covenants. Specifically, if a surety bond satisfies debt service reserve fund requirements, the bond indenture should be reviewed to determine the effect of the downgrade, whether replacement or other action will be required and, if so, the timeframe for accomplishing the remedial action.
The public finance lawyers of Squire, Sanders & Dempsey L.L.P. are monitoring these developments and working with various issuers and conduit borrowers to assess their impact, evaluate alternatives and execute solutions. For assistance, please contact the Squire Sanders public finance lawyer with whom you usually work, or any of our public finance lawyers, who may be contacted via the link in the sidebar.