California Bonds Fail on Advice Bill Lockyer Couldn’t Refuse

By Michael B. Marois

Dec. 17 (Bloomberg) -- For California Treasurer Bill Lockyer, the offer from Goldman Sachs Group Inc., JPMorgan Chase & Co. and Citigroup Inc. was too good to refuse.

If California was willing to forgo competitive bidding for a $4.5 billion bond offering, the banks promised more orders from individuals and a lower bill to the taxpayers. The firms insisted that by negotiating with them, the state would benefit from its special relationship with the Wall Street troika and wind up with what two underwriters called a salutary “buzz” to boost demand for the debt.

When the October offering failed to sell as planned, California was forced to accept 8 percent less money than it needed and to pay as much as $123 million more in interest than the banks said was sufficient for the market. And the threesome made $12.4 million on the deal, contributing to record bonuses in the securities industry a year after getting a total of $80 billion in a federal bailout.

“Just because someone earns a big wad of money doesn’t mean that they can do what they say they can do,” said Marilyn Cohen, who watched the sale unfold from Los Angeles as president of Envision Capital Management, which oversees $250 million in bonds for individuals. “And shame on the state if they were drinking that Kool-Aid.”

The California sale helped send the municipal-bond market to its worst month in a year. It ended a rally that had pushed borrowing costs for cities and states to a 42-year low, as measured by the Bond Buyer’s index of 20-year general obligation bonds.

Familiarity Over Price

California, with a bigger economy than Russia’s, seeks bids for everything from building roads and schools to buying portable toilets and fire extinguishers. When the state with the worst credit rating sells municipal bonds, it usually chooses bankers through a negotiation process that lets experience and familiarity trump price.

For the October deal, state Treasurer Lockyer picked the world’s most profitable investment bank and the nation’s two biggest bond underwriters, which together have sold $31 billion of debt for California since he took office in 2007. The U.S. municipal bond market’s largest borrower has sold tax-backed debt nine times this year, for a total of about $37 billion, more than four times second-place New York’s total, data compiled by Bloomberg show.

‘Conflicts’

The state’s former public finance director, Juan Fernandez, worked on the sale as JPMorgan’s executive director in San Francisco. Goldman’s bankers included Kathleen Brown, a former state treasurer. She’s the daughter of one past governor, Pat Brown, and the sister of another, current Attorney General Jerry Brown.

“The whole business is full of conflicts, and that’s a gigantic problem,” Cohen said.

Goldman, JPMorgan and Citigroup declined to comment, as did Fernandez. Kathleen Brown didn’t respond to phone and e-mail messages.

The $2.8 trillion market for state and local government bonds used to be more competitive. In 1970, 73 percent of municipal offerings were sold at auctions, the General Accounting Office said in a 1983 report. In such deals, the bank that offers the lowest interest cost via the highest bid, or price, buys the securities and tries to sell them for more.

This year, 16 percent of $368 billion in new fixed-rate issues were sold that way, Bloomberg data show. The rest were negotiated offerings, in which underwriters are selected before the sale based on assurances they’ll deliver cheaper rates by lining up investors.

‘Bad Week’

When the New York banks’ promises to California proved unreliable, Lockyer, 68, not his underwriters, tried to explain the miscalculation to taxpayers.

“It turned into a bad week for bonds,” the treasurer said in an Oct. 9 interview. “This seemed to be a very hard week with some headwinds for issuers.”

The underwriters left Lockyer “standing on the platform alone,” said Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board in Alexandria, Virginia, a self-regulatory organization. Taxpayers “probably didn’t get their money’s worth because California only got someone taking orders,” he said. “They didn’t get somebody out there that had any really strong incentive to sell.”

Banks don’t want “any unsold bonds hanging around,” so they prefer to help states set rates and see if the bonds sell, as happens in negotiated deals, Taylor said. If demand falls short, the dealers say, “Listen, we can’t sell this” without higher yields, he said. “It’s a wonderful world that the dealer community has created -- just fees, no risk.”

Saving a ‘Boatload’

Lockyer has no regrets about using a no-bid process because an auction would have led to even higher interest costs, said Tom Dresslar, his spokesman. While auctions may be effective for smaller issues, multibillion-dollar sales of both taxable and tax-exempt bonds like this one require advance marketing that banks will deliver only if they are hired beforehand, he said.

“We have saved taxpayers a boatload of money through negotiated bond sales,” Dresslar said, citing an analysis in the winter 2008 issue of the Municipal Finance Journal that was funded by the Securities Industry and Financial Markets Association.

The authors concluded that competitive sales have “no general advantage” and criticized past studies that found interest costs on negotiated sales were as much as 70 basis points, or 0.7 percentage point, higher.

True Interest Cost

California’s estimate of the so-called true interest cost on the tax-exempt portion of the October sale indicates it spent more the last time it sold competitively.

Including fees, the $1.3 billion negotiated sale cost 33 basis points less than the national average for 20-year general- obligation bonds at the time, excluding a risk premium of almost 1 percentage point the state paid after approaching insolvency, Bloomberg data show. When the state sold $1.1 billion in tax- free securities at auction on Feb. 14, 2007, the cost was 13 basis points over the average.

“Even though they couldn’t sell as much as they wanted, and even though they sold at yields at higher levels than what they wanted,” the deal “went well from California’s point of view,” said Gary Pollack, who oversees $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “They were able to borrow $4.1 billion at relatively historically low yields.”

After the sale, several states scaled back borrowing plans as municipal bond yields climbed the most in two weeks since December.

‘Litmus Test’

Maryland sold $200 million of debt on Oct. 21, about 25 percent of what it had wanted to offer, Bloomberg data show. Minnesota issued $576 million of bonds, or 64 percent of its planned total. Hawaii and Washington took similar steps after rising yields erased projected savings from refinancing.

“California’s large offering proved to be a litmus test for investors’ tolerance for new supply at relatively low yields,” said Chris Holmes, a fixed-income strategist at JPMorgan in New York, in a note to clients after the sale. It “set a tepid tone for subsequent large offerings by other issuers,” he said.

Municipal yields rose almost half a percentage point from their 3.94 percent low following the sale and were a quarter- point above that mark as of Dec. 10, the weekly Bond Buyer index shows.

Unemployment

California is strapped for cash amid the worst global recession since World War II. The most-populous state’s personal income tax revenue fell 33.4 percent in the second quarter, compared with a 27.5 percent national average, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. Unemployment in California was 12.5 percent in October, the worst since at least 1976. Nationwide joblessness was 10.2 percent in October, a 26-year high, and 10 percent in November.

The October sale was California’s first long-term debt offering since Republican Governor Arnold Schwarzenegger and the Democratic Legislature settled a three-month impasse over how to erase a $24 billion deficit in July.

The stalemate, which put the state on the brink of insolvency for the second time this year, ended with the approval of an $85 billion budget. California has cut spending by $32 billion, raised taxes by $12.5 billion and papered over $6 billion in shortages with borrowing and what Pacific Investment Management Co.’s Bill Gross has called “accounting tricks that couldn’t fool a grade-schooler.”

Imminent Downgrade

The July compromise prompted credit-rating companies to remove California from lists of borrowers facing imminent downgrades. The state’s general obligation bonds are graded BBB by Fitch Ratings, Baa1 by Moody’s Investors Service and A by Standard & Poor’s.

Public Resources Advisory Group, a financial consultant for the state since 1991, recommended a negotiated sale instead of a competitive one, a memo obtained through California’s Public Records Act shows. In past auctions, winning underwriters couldn’t line up enough buyers ahead of time, so “they bear more risk and the price they are willing to pay the state for the bonds will likely be lower,” increasing taxpayers’ interest costs, the New York firm wrote.

If the consultant “had not recommended a negotiated sale, had they recommended a competitive sale to get the best deal for taxpayers, that’s what we would have done,” said Dresslar, the treasurer’s spokesman.

Taylor, the former MSRB official, said financial advisers rarely recommend auctions.

‘Blackballed’

“The FA has no incentive to irritate the underwriter community by pushing the risk on them,” he said. “Any FA that pushes a competitive sale is going to get ‘blackballed.’”

Lockyer’s staff advised him on Aug. 24 to hire Goldman and JPMorgan to manage a $3.2 billion mix of taxable debt, including federally subsidized Build America Bonds, and Citigroup to lead the simultaneous sale $1.3 billion of tax-exempt securities.

Goldman, which accepted $10 billion in bailout money last year and repaid it eight months later, produced a $3.44 billion profit in the second quarter, a record for a U.S. investment bank. Its shares have almost doubled this year. JPMorgan, which has repaid its $25 billion bailout, is this year’s top U.S. bond underwriter, according to Bloomberg data that excludes municipal issues. Its shares are up 31 percent.

JPMorgan’s investment bank and Goldman will set aside an unprecedented $32.1 billion for compensation this year, according to an estimate by David Trone, a Macquarie Securities Group analyst. That will produce record bonuses totaling $19.3 billion, based on New York pay consultant Options Group’s estimate that year-end awards usually account for 60 percent of compensation costs.

‘Lowest Borrowing Costs’

Second-ranked underwriter Citigroup is repaying $20 billion of its $45 billion bailout to escape U.S. Treasury Department- imposed pay restrictions as the government prepares to sell its remaining stake in the company to recover the rest. The shares are down 49 percent this year.

The three banks were told by California in Sept. 21 engagement letters that they were expected to “perform at the highest level to assist this office in achieving a successful sale at the lowest borrowing costs.” The sales syndicate also included Bank of America Corp.’s Merrill Lynch & Co., Siebert Brandford Shank & Co., Wells Fargo & Co. and about 30 other banks and brokers that made $13.4 million on the deal, for a total of $25.8 million in fees.

Before selling the long-term bonds, Lockyer shored up the state’s finances by borrowing $8.8 billion through one-year cash-flow notes, a routine move used to pay expenses while awaiting anticipated tax revenue.

Record Demand

That Sept. 23 offering, run by JPMorgan, attracted twice as much demand from individual investors as from mutual funds and other institutions. So-called retail orders totaling $6.64 billion, about 75 percent of the sale, was the most ever for a municipal issue, Lockyer’s office said, citing underwriters’ data.

California paid as much as 1.5 percent on the debt, more than twice New Jersey’s cost for similar securities in August. The yield was in the low range of what had been advertised beforehand, and individual demand allowed the state to turn away $430 million in orders from institutions.

“Investors clearly know a good deal when they see one, and California taxpayers will benefit as a result,” Lockyer said after the sale.

That same day, Citigroup told Lockyer that the state would get a “vigorous pre-sale marketing effort” to “the broadest possible audience of potential investors” and “greater retail participation” for October’s long-term debt sale if he agreed to a negotiated deal, according to a letter from Chris Mukai, a director for the bank in Los Angeles.

‘Very Little Incentive’

When banks have to bid for bonds, they “have very little incentive” to find investors beforehand because they don’t know if they’ll “have the bonds to sell,” Mukai said. Underwriters in negotiated offerings “market the state’s transaction for at least a week in advance,” his letter said. “As a result of these efforts, Citi and the other underwriters will acquire accurate information as to the depth of buying interest, which is invaluable in the pricing of the issue and in securing the lowest possible borrowing costs.”

Mukai reminded Lockyer that Citigroup had helped JPMorgan sell September’s short-term debt to individuals, “saving the state millions of dollars,” and had implemented California’s “Enhanced Retail Marketing Plan” in June 2007.

“We believe all the retail marketing efforts in these past few negotiated sales have achieved tremendous success for the state,” leading to more than $8.1 billion in general-obligation bond sales to individuals, or 46 percent of new issues, Mukai wrote.

‘Buzz’ Memo

Goldman and JPMorgan offered Lockyer similar assurances in a joint Oct. 6 memo outlining how they would help draft an offering document, design a sales presentation and perform “pre-marketing and price-discovery activities” to help structure the issue at the cheapest yield.

“This process will generate a ‘buzz’ around the transaction, ultimately generating maximum investor participation in the sale, which we believe will translate into lower borrowing costs,” wrote Tim Romer, a Goldman managing director in Los Angeles, and JPMorgan’s Fernandez, who had been the state’s finance director from 2002 to 2006.

The two firms “strongly believe that proceeding with a negotiated sale” of the bonds “will result in a more cost- effective sale than a competitively bid transaction,” they wrote.

Lowest Since ‘67

Investors, including Envision Capital’s Cohen, predicted the October sale would go well, given the popularity of Build America Bonds, securities created by President Barack Obama’s economic stimulus package, which covers 35 percent of their interest costs.

As of Oct. 1, state and local governments had sold at least $36.9 billion of the debt, about 14 percent of year-to-date borrowing. The bonds attracted buyers to the municipal market and reduced tax-exempt supply, helping drive down average yields to 3.94 percent, the lowest since 1967, from 4.92 percent on April 2, the Bond Buyer’s index shows.

“There seems to be a voracious appetite for the BABs bonds no matter who the issuer is,” Cohen said in an interview the day before the sale. As for the $1.3 billion tax-exempt portion, “they should have a relatively easy time selling it because it’s not so huge,” she said.

Increasing Supply

In the weeks before the bond sale, Lockyer’s staff watched yields slide as state and local authorities kept issuing more debt to lock in low rates. Borrowers were benefiting from the recovery following the financial meltdown that had spurred a rush to the perceived safety of Treasuries after the collapse of Lehman Brothers Holdings Inc. a year earlier.

About $270 billion in new municipal bonds had been issued from Jan. 1 to early October, 16 percent more than at that point in 2008. California’s 2009 tax-backed bond and note sales totaled $23.4 billion by Sept. 30, up from $4.6 billion and $10.6 billion in the first three quarters of 2008 and 2007, respectively.

Demand might wane “because we are at lows in terms of absolute yield levels,” said Peter Hayes, who oversees $106 billion in municipal bonds for BlackRock Inc., on Oct. 6.

California officials said they knew the bonds would be a harder sell than the September notes. To keep debt payments low, Lockyer loaded the tax-exempt portion with maturities longer than what individual investors typically buy.

‘We Got Spoiled’

“We are so used to getting 50 percent, 60-plus percent, 80 percent retail,” said Dresslar, the Lockyer spokesman, referring to how much individuals bought of an offering. “We got spoiled,” he said. “We were fully cognizant that this was not going to be a walk in the park.”

Deputy Treasurer Katie Carroll and Public Finance Director Blake Fowler flew to New York to monitor the sale, accompanied by Dresslar.

Fowler, 43, has spent most of his career in municipal bonds. A year ago, Carroll, 53, gave a talk on “ways to maximize demand” from individuals to the National Association of State Treasurers. Then in Fowler’s job, Carroll emphasized the value of advertising on radio and giving retail buyers a two-day “priority period” for placing orders.

Day One

The bankers went into the sale telling investors California would pay tax-exempt yields from 2.87 percent for the 2015 maturity to 4.63 percent for bonds due in 2029. The 20-year was 23 basis points lower than indicated at the time by a Bloomberg index designed to gauge the fair value of similar bonds. The estimate for yields on taxable securities available to individuals ranged from 3.5 percent to 3.75 percent.

On Oct. 6, the first day of retail sales, the three California officials sat in a conference room in Barclays Capital’s New York headquarters on Seventh Avenue. As they talked to credit-rating companies about another bond issue, they monitored orders for the current one, which the London-based bank helped sell.

They phoned in updates to Lockyer. With Municipal Market Advisors data showing yields already starting to rise, individuals bought 28 percent of the tax-exempt bonds and 25 percent of the taxable debt, less than half the demand seen on the first day of the September sale.

The underwriters “told us before the deal not to expect the level of retail that we had been getting,” Dresslar said. By the time of the sale, they painted an even gloomier picture of concessions that investors wanted “to get the deal done at least close to the size” California wanted, he said. “Some of the numbers that were coming out were startling.”

Day Two

The following morning, the three officials and their financial advisers were ushered into a conference room in Goldman’s 85 Broad St. headquarters. Fueled by coffee, pastries and sandwiches over a 10-hour day, they decided to raise yields by as much as 4 basis points on tax-exempt bonds to attract more orders.

The market’s response “may reflect some anxieties with the retail investors in buying anything that’s longer” than one- year notes, Lockyer said on Bloomberg Television that day. “It may be pricing. It’s hard to tell.”

By the end of the second day, retail buyers had placed orders for $427.7 million, or 33 percent, of the $1.31 billion tax-exempt portion and $77.5 million of the $250 million of taxable bonds available to individuals. All together, retail sales amounted to 11 percent of the $4.5 billion the state wanted to borrow.

Day Three

The next morning, the California officials moved to Citigroup’s offices to finish the offering with sales to pension plans, hedge funds, nonprofit groups and other professional buyers.

“We’re depending on the institutional investors to make this work,” Lockyer had said on TV.

In a room off the trading floor, the officials decided to cut the sale to $4.14 billion -- $1.31 billion in tax-exempts, $1.75 billion in Build America Bonds and $1.07 billion in other taxable bonds.

They also increased some yields again as institutions grew more wary of the state’s finances. Tax-exempt rates ended up 8 to 37 basis points higher than estimated, including the 20-year, which was boosted to 5 percent from 4.66 percent. Debt due in 2025 went to 4.69 percent from 4.42 percent. Four taxable issues, including the Build America Bonds, cost the state 12.5 to 25 basis points more than the low end of estimated ranges. Two priced at the high end, and two were above it.

Extra Interest

The yields, averaging almost a quarter-point more than estimated, will result in California paying $8.1 million a year more in interest than it would have at the lower rates. If the bonds all are outstanding at maturity, the extra interest would total $123.5 million, data compiled by Bloomberg show.

“It’s justified for Cal to be paying a little higher price in order to sell its debt, given its credit issues,” Deutsche Bank’s Pollack said in an interview that day. “Their budget was not as tight and strong as I think a lot of people would have liked it to be.”

The sale’s biggest maturity, $1.75 billion of 30-year Build America Bonds, was priced to yield 7.23 percent, 95 basis points more than comparable corporate bonds and 325 basis points more than Treasuries with similar maturities. With the subsidy, California’s net cost is about 4.7 percent. Ten-year Burlington Northern Santa Fe Corp. bonds with the same Moody’s ratings as California traded at 122 basis points more than Treasuries that same week.

‘Best Shot’

“They just got a little aggressive in where they wanted to price it,” said David Blair, a Pimco analyst in Newport Beach, California, the day after the sale. “Most people still recognize that there’s budget deficits the state is trying to deal with,” said Blair, whose company oversees $20 billion in municipal bonds.

Lockyer’s spokesman portrayed the sale as a success.

“To say that the market conditions were not as favorable as they had been doesn’t mean that you go in conceding hundreds of millions of dollars; you go in and give it your best shot because there’s a lot at stake,” Dresslar said.

“Given the cold market and the inhospitable attitude of investors, to pull off a $4.1 billion deal, we believe, is an impressive achievement,” Dresslar said. “We would have been derelict in our duty to taxpayers if we sold a bond of this size through a competitive sale. We would have gotten hosed.”

Highest Rate

By Oct. 15, 20-year yields had risen 0.38 percentage point to 4.32 percent from its previous low, the biggest two-week increase in 10 months, the Bond Buyer index shows. California has since sold $7.3 billion in debt. On Oct. 22, it paid 8.361 percent on $250 million of lower-rated Build America Bonds -- then the highest coupon rate for a $100 million-plus issue since the program began.

A week later, the state was able to cut estimated yields as much as 0.15 percentage point on $3.5 billion in better-rated tax-exempt bonds when individuals placed orders for almost 72 percent, including debt due in 2022 that cost the state 4.85 percent, up from 4.47 percent in the early October sale.

California sold $908 million in Build America Bonds on Nov. 3, pricing the 30-year securities to yield 7.26 percent, or 3 percentage points more than Treasuries, down from October’s 3.25-point spread.

Lockyer has said the state may issue more debt before the fiscal year ends on June 30 without specifying how much.

“Everybody thinks there’s still an appetite for California bonds,” the treasurer said in the Oct. 9 interview. “If the market is inhospitable, we won’t go,” he said. “We’ll just have to wait and see how the feelings are when we get ready to think about it again.”

Tom Dalpiaz, who helps Advisors Asset Management oversee $3.3 billion in Melville, New York, said California and its bankers had flooded a glutted municipal bond market with too much supply.

The sale gave investors “sticker-shock syndrome,” said Dalpiaz. “It was a very large bond issue to digest.”