Bloomberg News

Investors Gain as California Agency’s ‘Discreet’ Bond Deals Leak

December 13, 2011

Dec. 7 (Bloomberg) -- The California Housing Finance Agency’s attempt to buy back $112 million in debt without a public tender offer backfired when word of the trades got out, saving the nation’s largest state home-lending authority millions of dollars less than it planned.

The agency, which funds first-time purchases for low-income homebuyers, hired Los Angeles-based bond firm De La Rosa & Co. without a competitive bidding process to help it reduce interest costs by buying back bonds below face value.

While De La Rosa promised to handle the transactions “discreetly,” prices rose in June after other investors learned of the debt buyback. One trader bought $22 million in bonds on May 25 and sold them to the agency three weeks later for a $3 million profit, trading data and agency records show.

“It doesn’t sound very discreet if everybody in the market found out about it,” said Christopher “Kit” Taylor, the former executive director of the Municipal Securities Rulemaking Board, a self-regulatory organization. “MSRB rules say you will treat the customer fairly. Is ‘fair’ giving up $3 million?”

The episode shows how even an agency with $10.2 billion in assets may not get the best prices in the secondary market for municipal bonds, where some securities rarely change hands. A small group of professional investors sets the prices, which can rise rapidly if a big buyer enters the market. On June 14, for instance, California paid 90.25 cents on the dollar for bonds it bought at 86.7 cents on the dollar the day before.

‘Better Result’

“There are approaches that might have a produced a better result for the HFA,” said Tim Schaefer, principal of Newport Beach, California-based Magis Advisors, a public-finance consulting firm.

The housing agency might have done better if it had held a public tender offer, forcing holders to reveal the prices at which they would sell their bonds and introducing competition to the process, Schaefer said.

California officials nevertheless say the buyback program was successful because it saved $6.8 million over redeeming the bonds at face value. Another buyback in December reaped savings of $18.2 million, said Bruce Gilbertson, former director of financing at the agency, who retired Dec. 1.

“Anything less than 100 cents on the dollar was going to be a good deal for the agency,” Gilbertson said.

De La Rosa, the 10th biggest underwriter of California bonds this year, wasn’t able to find holders willing to part with their bonds from February until June, and the agency got the best prices it could, he said.

‘Very Inefficient’

“I don’t think the secondary market for municipal bonds is perfect by any means,” Gilbertson said. “It’s very inefficient.”

The De La Rosa partner who negotiated the deal with California HFA was Paul Rosenstiel, a former deputy and campaign aide to state Treasurer Bill Lockyer. While working in Lockyer’s office, Rosenstiel oversaw debt issuance by the state, the biggest seller of municipal bonds.

In an e-mailed response to questions, Rosenstiel acknowledged that word got out about the big trades the housing agency wanted to do -- and that prices spiked after that.

“At a certain point during the spring 2011 tenders, many market participants became aware that Cal HFA was seeking to buy bonds,” Rosenstiel said. When investors figured out Cal HFA was the buyer and why it was buying, they sought to sell their holdings at higher prices, he said.

At that point, with the agency’s permission, De La Rosa publicly disclosed that California HFA was its client and sought the best prices it could get, Rosenstiel said. The purchases ultimately totaled $93.8 million.

Former Aide

Gilbertson said the agency didn’t choose De La Rosa because of Rosenstiel’s status as a former aide to Lockyer, who has also served as California’s attorney general. It chose the firm to do the buyback because it wanted something “less visible” than a Wall Street bank to conduct the purchases, Gilbertson said. De La Rosa made more than $278,000 in trading fees, according to MSRB and California HFA trading records.

In the e-mail, Rosenstiel said he didn’t oversee California HFA when he was a state finance official.

After learning that the agency was interested in a repurchase of up to $200 million of home-mortgage revenue bonds, De La Rosa offered its services in May 2010, according to a copy of the proposal obtained under a public-records request. California HFA gave De La Rosa lists of the bonds it wanted to buy, specifying the maximum it was willing to pay.

De La Rosa, which trades about $1 billion of California bonds in the secondary market every month, said it could identify current holders of the debt, monitor trading and evaluate prices, according to its proposal.

‘Executed Discreetly’

“The program would be executed discreetly to help ensure that California HFA achieves fair market prices for the bonds,” the proposal said.

De La Rosa, in fact, boasted about its track record of discretion. When the firm conducted a $38 million buyback for California in 2009, “investors did not catch on to the fact that we were purchasing bonds on behalf of the state,” the proposal said.

The trades by California HFA came at a time when it needed all the extra cash it could get.

The agency had a $117 million operating loss for the fiscal year that ended June 30 because of delinquent mortgage loans and foreclosures.

California HFA would have more than doubled its savings to $17.6 million on the June purchases if it bought the bonds at prices that reflected their six-month average yield above top- rated municipal debt, according to data compiled by Bloomberg.

$10 Million

For example, on June 14, the agency bought $10 million of its bonds maturing in 2030 at a yield of 5.3 percent and price of 93.5 cents on the dollar. The yield was 1.17 percentage points more than AAA-rated bonds of the same maturity that day.

In the previous six months, the same bonds traded 85 times, averaging 2.4 percentage points more than top-rated debt, which would translate into a price of 81 cents on the dollar, Bloomberg data show. If the agency had bought the bonds at that price, it would have saved $1.9 million, compared with the $650,000 it actually realized.

For the other 16 bonds HFA purchased in June, Bloomberg data show that the agency could have saved $15.7 million if it purchased the debt at average six-month spreads.

‘Aggressive Buyback Program’

“If you have an aggressive buyback program, by definition, you’ll leave something on the table,” said Schaefer. “But I’m not convinced that much of a markup is appropriate.”

Rosenstiel said many factors can affect the price of municipal bonds and that the average figure “is no indication” of what the securities’ value should be at any given time.

California HFA would have saved a total of $11.6 million if it had bought the same bonds at the minimum yields it told De La Rosa it was prepared to pay in May, according to Bloomberg data and a list of bonds the agency gave De La Rosa.

HFA can use money it gets when borrowers prepay mortgages to buy back its own debt within 30 days of Feb. 1 and Aug. 1, the dates by which it must redeem the bonds at full value.

The June purchases came in the days before the agency was required to give notice of its Aug. 1 redemptions. As that date neared, HFA was willing to pay more for its bonds, Gilbertson said.

Pressure to complete the purchases by the deadline may have cost the HFA money, said Larry Harris, a professor of finance and business economics at the University of Southern California’s Marshall School of Business and a former chief economist at the U.S. Securities and Exchange Commission.

‘Better Execution’

“It’s possible that had they been less pressured, they might have attained a better execution,” said Harris, who is based in Los Angeles.

Some investors who sold debt to California HFA made big profits.

For example, on May 16, Standard & Poor’s cut the agency’s home-mortgage revenue-bond rating three levels to BBB, a downgrade that should have depressed prices. Nine days later, an investor bought $22 million of the agency’s debt at 78 cents on the dollar, according to MSRB data.

The investor, whose identity couldn’t be determined, purchased the bonds from a subsidiary of MetLife Inc., according to records on file with the National Association of Insurance Commissioners. Barclays Plc brokered the deal.

Three weeks later, on June 14, California HFA bought the same bonds at 91.8 cents on the dollar, according to trade records obtained from the agency. The investor who bought the bonds for 78 cents on May 25 made $3 million.

‘Hard to Believe’

“I find it very hard to believe that the investor just got lucky, especially after the downgrade,” said Taylor, the former MSRB chief.

According to Gilbertson, De La Rosa got a call on June 14 from someone who asked if the dealer wanted to buy the bonds. A negotiation ensued and the best price De La Rosa was able to get was 91.8 cents, Gilbertson said.

If California HFA had known it could buy the debt for 78 cents in May, it would have tried to do that, Gilbertson said.

“We would have been all over those bonds,” he said. “For whatever reason, they didn’t really shop it out there in the secondary.”

Rosenstiel said De La Rosa wasn’t authorized to buy bonds for the agency at that time.

Tender Offer

Schaefer, the municipal adviser, said California HFA might have done better by forcing holders to reveal the price at which they would sell their bonds in a tender offer.

The cost of that, including legal fees for disclosure documents, would have been too great, Gilbertson said. The agency also wasn’t sure how much cash it would have on hand to buy bonds, he said.

While Gilbertson said that any purchase at a price lower than 100 cents on the dollar was a good deal for the agency, Harris, the USC professor, had a different perspective.

“Whenever anybody buys something for more than it’s worth, they end up losing, even if they think that they’re winning,” Harris said.

--With assistance from Michael Marois in Sacramento. Editors: Jeffrey Taylor, Pete Young

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net

To contact the editor responsible for this story: Jeffrey Taylor at Jtaylor48@bloomberg.net


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