2.3.2.3 Letters of Credit
Letters of credit are issued by most banks, but only highly rated banks are used to secure municipal debt. Some highly rated financial institutions may issue facilities that, although not “letters of credit,” operate like letters of credit and are referred to generally as “credit facilities.” A letter of credit can be a standby letter of credit or a direct pay letter of credit. With a standby letter of credit, the trustee for the debt draws under the letter of credit only if the issuer fails to make a payment or files for bankruptcy. With a direct pay letter of credit, the trustee draws under the letter of credit to make all payments on the debt, with amounts paid by the issuer as debt service being used to reimburse the bank for those draws. Letters of credit can also provide liquidity support to pay the purchase price of variable rate bonds tendered but not remarketed. Because they better address bankruptcy concerns, direct pay letters of credit are more common than standby letters of credit. Letters of credit are often referred to as “LOCs,” but because “LOC” is also an acronym for “line of credit,” “LOC” should be used for “letter of credit” only when the context is clear.
A draw on a letter of credit to pay debt service is treated as an advance from the bank to the issuer. If the advance by the bank is not immediately reimbursed, the issuer must pay interest to the bank at an agreed rate (e.g., prime plus 2%) that is usually higher than the interest rate on the debt. The issuer must enter into a reimbursement agreement with the bank providing for the issuance of the letter of credit and for the reimbursement. Reimbursement agreements also include representations, warranties, covenants, and default and remedy and other provisions common to credit agreements. Unlike bond insurance, issuers pay letter of credit fees only partially up front and pay most fees over the term of the letter of credit. Letters of credit are usually available only for a limited initial term, often 2 or 3 years and rarely more than 5 years.