Over the last 10 years, the long-term new issue municipal market has averaged $226 billion per year, ranging from a high of $292 billion in 1993 to a low of $160 billion in 1995. In 2001, total long-term, new issue volume was $286 billion. Refunding volume, primarily a function of current and historical interest rates, is the largest variable in overall volume, although infrastructure needs, taxpayer sentiment, and tax and environmental legislation are also factors. New issue note volume tends to be smaller, averaging $43 billion per year over the last 10 years. There is approximately $1.6 trillion of outstanding municipal debt.

Currently, the structure for passing through tax-exempt income from single or multiple municipal bonds is a statutory or common law trust that is a partnership for federal tax purposes. The securities issued are generally secondary market synthetic floating-rate securities, or more commonly known as tender option bonds (TOBs). TOBs are variable-rate trust receipts created from fixed-rate bonds that have been deposited in a trust generally created under the laws of New York. The underlying bonds can be from various obligors with different types of bonds (e.g., general obligation, education, industrial revenue, etc.), different geographic locations, maturities and interest rates but typically with consistent minimum credit ratings. Typically, the assets to be securitized are identified prior to the close of the structure but may also be structured to permit expansion through the issuance of additional securities for the purpose of acquiring additional assets that satisfy specified eligibility criteria and subject to mandatory tender of the TOBs.

Moving a TOB into a CDO-like structure requires some changes from a structural and ratings perspective. These changes may include multiple classes, hedging strategies, overcollateralization and ratings methodology.

The CDO, like a TOB, will combine incoming cash flows from the bonds and reconstruct the cash flows into a priority structure. While TOBs generally have one senior class, CDOs benefit from tranching the risk into multiple classes with potentially different interest rates (spreads) and tenors.

As for hedging, typically TOBs have a mismatch between short-term liabilities that are floating-rate and assets that are long term and fixed-rate. Interest rate exposure in TOB structures is managed through the relationship of the amount of TOBs and residual interest certificates issued and the methods for the allocation and distribution of available tax-exempt income by the trust. In addition, interest rate exposure may or may not be hedged separately from the trust structure. Mitigation of interest rate exposure is a key element within a CDO and needs to be considered when developing the CDO-like structure for municipal bonds.

TOB structures generally have sufficient underlying bonds to cover issued securities and fees. CDO structures may contain a higher par amount of bonds. The excess cash flow would be used as credit enhancement. This option would require additional legal review to ensure preservation of true sale and tax-exempt status.

As for methodology divergences, TOB structures generally match the long-term rating of the TOBs with the lowest rated bond in the trust. CDO rating methodology looks not only to the underlying collateral but also to the structural protections within the transaction.

Fitch anticipates using its established cash flow CDO methodology as a basis for rating CDO-like structures for municipal bonds. This involves analysis of the CDO structure, the underlying pool of assets, the soundness of the legal documents and the strength of the sponsor/manager. Once the transaction structure and asset pool have been reviewed, Fitch runs numerous cash flow stress scenarios to determine if the subordination levels and priority of cash flows are sufficient to meet the requested ratings.

Default experience

In September 1999, Fitch published a default study on municipal bonds (see "Municipal Default Risk," Sept. 15, 1999). The results of the study indicated that municipal bonds, as a class, were very low risk, with 13- to 20-year cumulative default rates of 1.49%. However, Fitch found a very wide dispersion of risk among various municipal bond types. For general obligation, water and sewer, transportation, public education and single-family housing bonds, the 13- to 20-year cumulative default rates were lower than 0.25%. However, other municipal bond types were found to be much riskier. Comparable default rates for municipal health care were 2.6%, electric power 2.8%, multifamily housing 4.9% and industrial development 14.9%.

Based on the default study findings, Fitch adjusted its outstanding ratings, upgrading about 25% of its general obligation bond ratings, 50% of its water sewer ratings and 14% of its airport bonds; Fitch lowered the ratings on 8% of the hospitals we rate. Fitch believes that default rates on municipal bonds, as currently rated, should more closely resemble default rates on similarly rated corporate bonds.

The amount and timing of recoveries on municipal bonds can vary greatly and will depend on the type of underlying security. For general obligation and tax-backed bonds issued by states, counties, cities, towns and other municipalities, Fitch would expect a very high recovery in the event there is a default. While a debt obligation may be recharacterized under the bankruptcy code, the ultimate obligation does not go away in the event of default or bankruptcy, and municipalities of this size invariably recover and resume paying debt service. Essential service, regulated, monopoly operations like water and sewer revenue bonds should also have similar recovery characteristics.

Bonds dependent on certain projects may not have such high recovery rates or may have long periods of nonpayment. For instance, the ramp-up in revenues created by a new toll road may take significantly longer than expected, resulting in insufficient cash to cover debt service. The bondholders may experience a long delay in payments of interest and principal, or the debt could be refinanced. Ultimate recovery may be high, but periods of default could extend for five years or more.

There are several highly visible examples of municipal revenue bonds with elements of corporate risks where defaults have been settled at recovery rates well below 100%. (These recovery rates are exclusive of any bond insurance provided to the investors.)

Because of the wide variation in municipal recovery rates, Fitch will stratify the timing and amount of recoveries based on the type of bond and its underlying purpose.

Applying default,

recovery and prepay stats

Defaults are applied to a cash flow CDO based on the weighted-average debt rating, industry concentration and weighted-average life of the pool of assets being securitized. Fitch built a default matrix for cash flow CDOs that provides benchmark default stresses to apply to an asset pool with a specific weighted-average debt rating for each desired liability tranche rating.

Fitch adjusted ratings on municipal bonds so that performance is likely to mirror corporate bonds in the future. Thus, the underlying securities in a municipal CDO will be evaluated using the cash flow CDO default matrix.

Recoveries, however, will be stratified by bond type (e.g., general obligation, student loans, hospitals, etc.), and a delay period will be assessed. Once recoveries are determined, the weighted-average recovery rate is applied against the weighted-average default rate to arrive at a net loss rate. Since the matrix described above assumes a 10-year average life, the net default rate will be adjusted depending on the weighted-average life of the assets.

Fitch will also apply a single obligor test. Its purpose is to cover a random event happening to a single obligor and protects the integrity of the structure against concentrations within the pool. The test will be tailored for different total numbers of obligors within a pool.

The preponderance of bonds eligible for a CDO-like structure will be fixed-rate. Generally, fixed-rate bonds have no call provisions for the first 710 years with optional redemption schedules (and declining prepayment premiums) thereafter. As expected, prepayments are more commonly seen in declining interest rate environments. Fitch will review the vintages and underlying interest rates in the CDO pool and will consider the effect of prepayments on the allocation of the capital structure and the relationship of the recalculated weighted-average coupon of the assets to the weighted-average rate of return to be distributed with respect to the issued securities.

Certain bonds (e.g., revenue bonds) contain extraordinary and mandatory redemptions upon the occurrence of specific events such as loss of tax-exempt status, receipt of insurance proceeds upon condemnation or destruction of the project, etc. Prepayments due to extraordinary and mandatory redemption requirements are rare and should not affect the CDO analysis.

To the extent that there is an interest rate mismatch between the underlying municipal bonds and the distributions to be made with respect to the CDO securities, the cash flow model will incorporate interest rate shocks. The rate shocks will be applied over the first several years of the transaction against the current rate to test the resiliency of the capital structure throughout a full economic cycle.

To conclude, opportunities exist to provide liquidity to lower rated, and in some cases, non-rated municipalities. Currently, these municipalities either obtain bond insurance (to bring their ratings to investment grade) or are forced to issue in the private market, which is fairly illiquid. A robust municipal CDO market could allow these issuers to access competitive funding in a more liquid environment without dependency on bond insurance. Therefore, a municipal CDO would be the next logical step in the evolution of tax-exempt structured vehicles.

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