This month, the Monitor provides particular insight into government financing gleaned from industry specialist De Lage Landen Financial Services. We spoke with Robert Neptune, president of De Lage Landen Public Finance, LLC and a 30-year industry veteran, to find out what makes the market unique and how it is coping with the current economic turmoil that is having a significant impact on the other financial markets.

MONITOR: In the last 25 years, have you seen significant change in the government leasing market?

ROBERT NEPTUNE: To understand today’s government leasing market, we need to trace its development from the beginning.

When I first entered the business in the 1970s, the municipal leasing business was very fragmented, with no major or dominant players. Twenty-five years later, the industry has grown tremendously but is still highly fragmented. The industry has had a few large players — usually no more than five or six at any one time. No single company or small group of companies has ever captured a significant percentage of the market. The characteristics of the business make it a classic niche market.

M: Who are the major players in this arena?

RN: Industry participation has been broad in terms of the types of companies involved, which include national banks, regional banks, local banks (large and small), independents, captives, and brokers and other third parties.

With the exception of local banks, there has not been a large number of players in each of these categories. Over time the major players have changed periodically for a myriad of reasons, including changes in ownership, changes in tax appetite due to profitability and corporate structure, and changes in market coverage or scope. Local community banks, albeit relatively unseen, have consistently been the largest group of players in the market. Many of the thousands of small municipalities and local governments simply go to their local banks to borrow what they need.

M: Why do state and local government entities require special financing?

RN: All 50 states have laws that restrict the ability of municipalities to borrow money. There are, however, fewer restrictions on the ability of municipalities to enter into leases. Generally, the government leasing business exists because state and local governments, as well as federal agencies, need supplemental capital that they can’t get through traditional sources such as tax revenues or bond financing.

Still, there are significant restrictions or risks associated with how they can obtain financing, including annual appropriation requirements, termination for convenience in the case of federal leases, tax and other reporting requirements, self-insurance requirements, and limits on indemnification, to name just a few.

Out of this set of circumstances was born an industry of lenders willing to accept these borrower idiosyncrasies and the risks involved, real or perceived.

M: People generally assume that government financing is less risky. Is this true?

RN: Although the players have changed periodically, the market has remained fairly consistent. One of the biggest changes has been the broader market realization that the actual risk of loss is very low. Market statistics are limited, but most in the market believe that the actual incidence of default before recovery could be as low as one tenth of one percent in the municipal leasing market. Losses in the federal market, while still very low, are higher than in the state and local market, due primarily to the risk of termination for convenience.

M: Does this low risk change the way companies approach the business in terms of pricing?

RN: The very low risk parameters of the market have resulted in several specific behaviors.

First, when the commercial leasing market experiences credit deterioration, the government leasing market becomes a target for the proverbial “flight to quality.” Second, the market pricing structure is fairly flat regardless of perceived credit differences; there can be very little pricing differential between AAA and non-rated credits. And third, pricing seems more related to market liquidity than to anything else.

When the municipal leasing business started, pricing was 100 to 200 basis points or more over a similar term A-rated municipal bond. In the recent past, leasing rates have been as low as or, in a handful of cases, actually below the rates for AAA-rated municipal obligations. While there is almost always a cowboy or two in the market, current rates have crept back up to a range of 100 to 125 basis points over AAA-rated bonds.

From the early 1980s through about 2000, most of the spread deterioration was due to a growing understanding of the very low inherent risks in these transactions and the recognition that they could be funded with lower capital requirements. More recently, however, I think pricing changes, particularly the very low pricing of the past few years, have been more about liquidity than anything else.

M: Recent headlines have shown that some of the larger players are exiting the government financing business. What is driving the exodus?

RN: The current market is a great example of how industry participants can shift with the winds of change. Several years ago when credit tightened in the commercial sector, a number of large regional and national banks moved into the government market in a big way. There was deterioration in the commercial markets, but no apparent lack of overall liquidity, so these banks moved money into the safer municipal market. As liquidity continued to increase over the next few years, both the large bank and nonbank financial institutions grew their government lease business tremendously.

The combination of excess liquidity and a flat or inverted yield curve created pricing that was almost completely disconnected from that of the large, traditional bond market. Many institutions priced to treasuries, which at times were right on top of tax-exempt rates. Some used flawed return models to calculate pricing. Some just wanted to employ funds in a safe way at any price, rather than leaving them unemployed. The government market was, and still is, the safest place to do that.

Within the last year, it has all come crashing down again. The niche business is always the easiest to exit because the level of investment and dedicated resources is usually small enough to dispose of with a minimum amount of corporate pain. Government leasing fits that bill perfectly, with even the largest players able to get out quickly when things get tough. And boy, did things get tough. National and regional banks suffered big hits to profitability and liquidity from the mortgage crisis, fallout from high oil prices, and bad investments. Nonbank lessors have been retreating due to internal investment criteria. And, several bond insurers have lost ratings, which, at least temporarily, closed certain avenues to passive capital.

M: What is the market impact when these types of players exit the business?

RN: The result has been a fairly radical swing of the pendulum in the other direction — another characteristic of classic niche markets. Many major national banks have either exited or significantly retreated from the government leasing market. Several of the large regional banks are out of the business at least temporarily. Two of the largest nonbank lessors have retreated substantially due to changes in their structure and/or their investment criteria.

The investment capital available in the “visible” governmental leasing market has diminished considerably. The NBQ [nonbank qualified] market has been hit hardest because there are fewer large nonbank investors. Even 
bank leasing companies that have the appetite for NBQ 
have limited capacity.

The bank-qualified market remains more active and much better funded. A significant number of small regionals still have not been hit hard by the current economic situation, and scores of local banks remain unscathed by the mortgage crisis and are more than willing to finance their local communities and school districts.

M: It sounds as if today’s environment is something the government leasing market has never witnessed before.

RN: We need to remember that this current situation is not new or unique. The underlying reasons may change, but the result is the same. I have watched the same banks get in and out of the business three or four times in the past 20 years. Nonbank lessors continue to come and go from the government market, depending on the success or failure of corporate diversification and profits.

Not unlike the commercial leasing business, the same people — the ones with the knowledge — move from one 
company to another as appetites wax and wane. The brokers remain the same. They just change whom they sell to.

M: How do market conditions affect government leasing compared to commercial leasing?

RN: One interesting aspect of the ups and downs of the business is that government finance does not always react to market forces in the same way as the commercial leasing market. The correlations can be direct, or they can be inverse.

When the economy slows down, or there is a “credit crunch,” sometimes government leasing slows down along with it. However, it can also react in an opposite fashion. A reduction in government tax revenues, depending on timing, can result in the need for governmental entities to actually borrow more money to maintain base-level, essential services. This includes the need to raise capital or secure financing to replace worn-out equipment and facilities.

Corresponding with that is the possibility that a commercial market with deteriorating credit quality will cause a significant flight to quality for investment capital. This often directs more funds into the government finance markets. The result is lower rates in the government market while commercial rates are rising.

M: So you’re dealing with multiple situations depending on various factors. What is the range of scenarios that can occur?

RN: We can wind up with different market circumstances depending on the root cause of the particular economic situation. The most common scenarios relate to the strength of the market and market liquidity (See Figure 1).

And let’s not forget that these market situations can be 
even further exaggerated by the continuous exits and entries of sizeable participants.

Ultimately, however, the overall appetite for tax-exempt investments across all investment markets doesn’t go away when the economy changes. It simply moves from one set of investors to another, from one group of profitable companies (and individuals) to another. Again, current market conditions provide a good example. The historically traditional market for tax-exempt leases has pulled its head back into its shell for a while. At the same time, investments in tax-exempt money market funds total 
several hundred billion dollars.

M: Do the same dynamics apply to the federal leasing market?

RN: The transaction structures are different. The federal business uses taxable FMV and dollar-out leases. However, many of the characteristics are the same. While the risk in federal leasing can be higher than the municipal market due to multiple termination options, with proper underwriting and attention to asset essentiality it is substantially safer than the commercial leasing market.

In many if not most respects, the federal market behaves as a niche market in much the same way that the municipal market does. Institutions get in and out depending on their liquidity, their desire for higher-quality assets, and their need to serve a vendor or partner constituency.

M: What are the market differences between municipal and federal leasing?

RN: One of the primary differences is that there are substantially fewer players in the federal leasing market. As a result, market changes and the exits and entries of participants can have a somewhat more dramatic effect on pricing and liquidity in the market.

Over the past five years, for example, pricing for financing long-term energy management projects without the 
normal termination risks has gone from greater than 200 basis points over like-term treasuries, to less than 100 basis points over treasuries. It is now, at least in some cases, back above 200. The credits haven’t changed, but the market participants have. The result was a significant change in liquidity and pricing. It required only a handful 
of withdrawals from this market to affect these changes.

M: So what does it take to be successful in the municipal and federal leasing business?

RN: Two keys to being in the government leasing business on a consistent basis are to have a recurring compelling reason to provide the products and the ability to fund the business through the full range of credit and economic situations. You might say that consistent appetite plus consistent funding results in consistent performance.

M: Most people aren’t familiar with De Lage Landen due to the private-label nature of your business, but you continue to be successful and an industry leader in this market space. Why have you experienced success while others have not?

RN: At De Lage Landen we have an overriding reason to provide government leasing on a regular and consistent basis. Our financing is offered through vendor partners almost exclusively. Regardless of the economy or profitability or anything else, our vendors are selling to government customers and they require financing for those sales.

We started De Lage Landen Public Finance in 2005 because of an overwhelming demand from our vendors. Satisfying that need is our number one priority. This year we will underwrite over $400 million of government business.

M: What is the most critical factor in your business?

RN: Being able to fund the business consistently is critical. You can’t satisfy your customers’ needs by periodically getting in and out of the business. At De Lage Landen we are funded by our parent, Rabobank, which is one of the few remaining AAA-rated banks in the world. It is also one of the largest, with over $600 billion in assets. This strong financial base enables us to consider development of alternative funding methods, which can access a broader market of investment capital, if necessary, to support the business.

M: Where do you see the government finance market headed in the future?

RN: We expect liquidity to remain somewhat tight in the government market through at least the third quarter of next year, if not until 2010. Some national and regional banks that have slowed down during the second half of this year will start creeping back onto the scene in January. If the economic situation improves, the banks and nonbank financial institutions will begin to accelerate their investment in the business. Nonbank qualified investors will lag behind the banks in this respect. As overall liquidity increases, investment in the government finance market will increase correspondingly.

We project that demand should continue to be strong well into 2010, as the effect of lower tax-revenues has a tendency to lag behind any economic improvement.

Overall, this should make the government finance market a good place to be during the next year or two. We can only hope that as the various players come back into the market, they will do so with a newfound sense of reason with respect to pricing.