Fitch working on new municipal CDOs in the US

Fitch Ratings is reviewing several pools composed mostly of already issued municipal securities as potential collateral for a new asset class – municipal collateralised debt obligations (CDOs). Marion Silverman, a senior director based in Fitch Ratings’ Chicago office, said she was not sure if the first municipal CDO would come to market before the end of the year, though she was confident Fitch would be one of the agencies rating the first such transaction.

Silverman said there was no change in investment markets driving interest in municipal CDO issues. In the past few years, there has been a rush to issue CDOs of new asset classes, such as private equity, trust preferred securities, middle-market loans and distressed debt. Silverman said municipal CDOs would fit in naturally with this trend.

Silverman said that for the past year Fitch has worked closely with potential issuers – municipalities – and investment banks established in public finance on developing the basic design for a municipal CDO structure. Investment banks would seek to issue municipal CDOs to remove municipal assets from their balance sheets - creating new risk-taking capacity. “We're really looking to some of the investment bankers and saying you have to help us figure out what sort of market is here,” said Silverman.

Municipal securities offer wealthy investors and institutional investors tax advantages, and a key issue in development of the new CDO class is to determine how full tax advantages on municipal securities investing can be transferred through the CDO structure. Fitch has retained Chicago law firm Chapman and Cutler to assess the matter. The existence of structures similar to CDOs that offer full tax advantage pass-through - tender option bonds - encourages Fitch Ratings officials that a solution is possible. Tender option bonds, also known as certificates of beneficial interest, are floating-rate securities linked to single or multiple municipal securities.

In its work on the pools of assets currently before it, Silverman said Fitch has assumed full tax benefit pass-through, though it has advised all potential underwriters to retain their own tax advisers on their individual deals. A potential complicating factor is whether use of interest swaps, gains on which are taxable, would interfere with the pass-through of the tax benefits of the underlying municipals.

Silverman said revenue bonds and general obligation issues from small municipalities that have not been able to afford to issue in current markets could be important constituents of municipal CDOs. Most municipals are highly rated and offer little spread opportunity for CDO investors. Revenue bonds are riskier. Small municipalities would gain if municipal CDO issues deepen secondary market trading in municipal issues, thereby lowering yields across municipal securities market. Further, use of the CDO structure could obviate the need for wrapping new issues by small, unrated or troubled municipalities, which can be a prohibitive expense.

CDO investors should be comfortable investing in small municipality CDOs, even were the issuer unrated, due to proven investor appetite for CDOs of other unrated assets and for middle-market collateralised loan obligations, whose underlying securities are not individually rated. Rather, their riskiness is assessed through rating agency mapping procedures.