CREDIT ENHANCEMENTS AND THE ROMANIAN MUNICIPAL BOND MARKET.

• Author: Pop, Cornelia

1. Introduction and literature review

   The importance of sub-national borrowing as an element of development strategy at municipal or local level is continually increasing given three important trends identified since the 1980s and discussed by Peterson (2000), Magrassi (2000), Venkatachalam (2005), Kehew, Matsukawa and Petersen (2005), Martell and Guess (2006), Canuto and Liu (2010), and USAID (2009). These trends are: a) the growing pace of urbanization which requires considerable infrastructure and urban services expansion; therefore the need for local investments is mounting and the demand for financial resources to support them increases accordingly; b) the decentralization trend, a process through which sub-national governments are granted increased responsibilities and more important roles in planning capital investments, establishing priorities, and implementing chosen projects; also the difficult responsibility for financing the needed investments is transferred to local governments; c) fiscal adjustments which require governments at all levels to reduce budget deficits; one of the favored instrument is the cut back of central government subsidies for local infrastructure financing; since sub-national governments rarely maintain cash surpluses necessary for medium and large-scale investment projects, this trend also enhances the need of local authorities for alternative financial resources as a way to support their development projects.

   As highlighted by Venkatachalam (2005), these three trends have challenged the traditional approach of fiscal federalism, under which borrowing at sub-national levels was not favored, especially in developing economies. Under the combined pressure of increased urbanization, fiscal adjustments and decentralization, central governments were pushed towards accepting the idea of local governments accessing private financing sources for their public infrastructure and service development investments. Moreover, the use of credit for these developments is supported by the idea of inter-temporal equity which requires future generations to partake in supporting the costs of current infrastructure investments, as highlighted by Peterson (2000) and Venkatachalam (2005). This inter-temporal equity is ensured through the standard rule holding that the period of a local debt repayment should approximate the useful life of the project, as such matching the time profile of costs and benefits (Peterson, 2000).

   While the importance of borrowing increases for local developments, the main challenge many small municipalities have to face is the difficulty to access private financing sources. The hardship is generated mainly by the relative small amount of capital needed for (potentially profitable) projects/developments, often combined with the lack of frequency in accessing market sources, which limit or even deny the access of local governments to market financing at attractive (borrowing) rates. Other factors that increase the difficulty of accessing private finance sources are: the limited credit experience, the limited knowledge of financial markets, and, when available, poor credit ratings. This difficulty of small local governments in accessing the market financing alternatives is briefly discussed by Noel (2000), Petersen (2006), Blommestein and Rhee (2009), and Schmith et al. (2011).

   Another problem that impairs local government access to capital market resources arises from the fact that investors are not always fully aware of the true credit quality of the municipal borrower/issuer given the infrequent access to capital market, which reduces the investors' familiarity with the respective entity; moreover, the analysis of a local government financial performances is a daunting task given the difficult access to financial information, as highlighted by Peng (2002). This problem is related to the creditworthiness of the municipal debtor or bond issuer. Sub-national governments can overcome the problem of creditworthiness through the use of credit enhancement mechanisms or techniques. Moreover, through credit enhancements the problem of small borrowed amounts can also be surmounted, since these mechanisms can help the issuer to market their debt to investors (Plate, 2009).

   Credit enhancements consist of a variety of provisions used to reduce the credit risk of a municipal debtor or municipal bond issuer, by providing additional collateral, insurance, and/or a third party guarantee that the debtor/issuer will meet its obligations (Petitt, Pinto and Pirie, 2015).

   Few academic papers are dedicated to discuss credit enhancement only since these mechanisms are closely linked with the credit market developments relative to sub-national borrowers. Among the most recent academic works discussing the credit enhancements are Plate (2009), Mandel, Morgan and Wei (2012), Schmit et al. (2011), and Petitt, Pinto and Pirie (2015). A comprehensive presentation of credit enhancements can be found in Ziegler (1985).

   Two main types of credit enhancements exist: internal, put in place by the debtor or bond issuer, and external, provided by a third party to the debtor or bond issuer.

   The internal credit enhancements rely either on the collateral value or on the structural features concerning the priority of payments (Petitt, Pinto and Pirie, 2015). According to Fabozzi et al. (2005) these credit enhancements influence the cash flow characteristics of the loan, even in the absence of default. Being put in place by the debtor, these credit enhancements are less costly, except the opportunity costs for reserve funds. Often, at least a form of credit enhancement is required to exist before external credit enhancements are put in place by a third party. The following types of internal credit enhancements are the most common in case of local governments borrowing: overcollateralization, reserve accounts or reserve funds, and debt subordination. These three types of internal credit enhancements are briefly presented below.

   The overcollateralization represents the practice through which the debtor or issuer of bonds offers collateral that has a greater value than the borrowed amount (Crawford, 2005; Banks, 2005; Petitt, Pinto and Pirie, 2015). The excess collateral pledged by the debtor creates a buffer that can cover a series of unexpected risks. Through overcollateralization, the debtor's credit profile becomes stronger and this might trigger a higher credit rating and lower interest rates for the borrowed amount. Thus, overcollateralization might prove to be expensive if the tied up collateral (mainly in the case of assets) cannot be used for other purposes. A supplementary mechanism that completes the overcollateralization is represented by the intercept of (central) state aid to local governments dedicated to meet debt service payments.

   Reserve accounts or reserve funds. A reserve account/fund is established either voluntarily by the debtor/bond issuer or at the request of the lender or guarantor. Such an account/fund might come in one of the two forms: a) a cash reserve fund [1] (Crawford, 2005) is a deposit of cash resulting from the cash proceedings; a portion of the obtained loan is placed in an escrow reserve account, out of the debtor's reach; a drawn against such account or fund is made if a loan installment is not paid when due; it might take the form of a hypothecated fund that typically is invested in money market instruments, and it is held at a custodian or trustee; this cash reserve account/fund is often used in conjunction with a letter of credit, an external form of enhancement; b) excess spread account (Petitt, Pinto and Pirie, 2015) is a reserve account funded by the excess spread; the excess spread is the difference between the cash flow received from the assets used to secure the issue and the interest paid to the investors; also, it can be funded by an extra interest paid by the debtor or bond issuer. The excess spread account is most often established in the case of debt subordination and is considered the first line of protection against credit losses; this account must be completely used (exhausted) before even the most subordinated tranches incur losses (Mandel, Morgan and Wei, 2012). Moreover, in a process called turboing, the excess spread account might be used to retire the principal (to pay the principal in advance) and thus, to reduce the default risk for the respective issue.

   Debt subordination, also called senior/subordinated structure, refers to the ordering of claims over a loan. According to Petitt, Pinto and Pirie (2015) and Crawford (2005) the loan/debt is structured in at least two tranches: a senior tranche (called class A) and a subordinate or junior tranche (called class B). The subordinated/junior tranche acts as a protective layer to the senior tranche; the subordinated/junior tranche will absorb any potential losses. Basically, the subordinated/junior is a buffer or collateral to the senior tranche. The senior tranche has priority claims, and is the first repaid in case of default, while the junior tranche incurs the losses. Moreover, the senior tranche is unaffected by losses unless these exceed the amount of the subordinated/ junior tranche. Due to this structure, the senior tranche has a high credit quality, a high rating, and a low yield. The junior tranche, given its high credit risk and the greater default risk exposure, is supposed to have a higher yield. Furthermore, the subordinated/junior tranche will have a low rating or no rating at all. Debt subordination is also known as waterfall structure and more than one senior and junior tranche might exist with various levels of claim priorities.

   The external credit enhancements, provided by a third party, increase the creditworthiness of the debtor. External credit enhancements bear a high cost, mainly for small local borrowers. Moreover, they expose both the borrower and the investors to the...