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ARS Still Weighing Down Issuers

WASHINGTON - Hundreds of municipal issuers of auction-rate securities are still grappling with failed auctions that have resulted in sky-high interest rates, eight months after broker-dealers stopped supporting auctions and the ARS market collapsed.

Though the tumult in the auction-rate securities market has shifted from the foreground amid the global financial crisis, issuers still have about $81.5 billion of ARS outstanding, according to statistics collected by Bloomberg LP.

The $81.5 billion figure, the bulk of which appears to consist of failed auctions, compares to about $170 billion of ARS sold by municipal issuers. Prior to its collapse, the entire auction-rate market was estimated at about $330 billion. The ARS market collapsed in mid-February when firms that historically supported the auctions of the securities, but were under no contractual obligation to do so, stopped propping them up. Since then, many issuers converted their ARS into variable-rate demand obligations with five-year put options.

Many issuers that have been squeezed by the high interest rates resulting from failed auctions have not refunded or restructured their debt either because they do not have the cash to buy up the bonds themselves or have been unable to get a letter of credit commitment from a bank to convert the debt to another mode because of the credit crunch, several sources said last week.

"Most issuers are just trying to survive and hope that rates come to a more reasonable level or that they'll be able to access credit," said one bond attorney who represents several nonprofit issuers, some of which are beginning to experience a deterioration in their underlying financial situations because of the high interest rates they have paid all year.

Though these issuers have dealt with failed auctions for months, the situation has been made worse in recent weeks by the volatile Securities Industry and Financial Markets Association's municipal swap index, on which some of the ARS interest rates resulting from auction failures were based.

Under the terms of several ARS bond documents, issuers agreed to pay 175% of the SIFMA swap index in the event of a failed auction. The index jumped to 7.96% in mid-September, though it has begun to decline back to its historically low levels, falling last week to 3.45%. The index is based on a basket of VRDOs, which, like ARS, are short-term notes, but feature a put option that allows the issuer to sell them to a bank if they cannot be remarketed. ARS typically have been backed by bond insurance and have not included put options.

"When our bonds were sold, SIFMA wasn't this far out of line," said Don Vickers, president of the Vermont Student Assistance Corp., which has a portfolio of about $1.7 billion of illiquid tax-exempt student loan ARS. Several tranches of the nonprofit student loan lender's debt have reset at failure rates above 13%, according to Bloomberg.

Taxable rates, which are often based on Treasury bills that have dropped to historic lows, are now lower in cost to issuers than tax-exempt paper, he noted.

Despite the failed auctions, Vickers said his agency continues to pay a fee for the issuer's broker-dealers to manage its portfolio of ARS. The fee is equal to 15 basis points per year, or about $2 million, he said.

"Obviously if we didn't have to pay them, we wouldn't, because there are no auctions taking place," he said.

Meanwhile, for other issuers with illiquid ARS, the situation has been compounded by broker-dealers that have merged with other companies or filed for bankruptcy.

In some of these cases, the underwriter has resigned as the transaction's broker-dealer and the auctions have continued to fail. In others, no auctions are taking place and the interest rate has been set at a predetermined rate that is separate from the failure rate, usually about 5% or 6%, according to a bond attorney here.

Under both scenarios, though, issuers generally have faced great difficulty finding replacement broker-dealers willing to manage the ARS, sources said.

An exception to this is the University of Medicine and Dentistry of New Jersey, which sold $37.7 million of ARS in 2001 that were underwritten by Lehman Brothers, which resigned as broker-dealer after its holding company filed for bankruptcy last month.

Roger Anderson, executive director of the New Jersey Educational Facilities Authority, said that his authority is working with Morgan Stanley to restructure the university's $33.4 million of outstanding ARS sometime late this year or in January. He said they are still reviewing their options and have not yet decided on a structure.

Anderson said that under the transaction's bond documents, when there is no broker-dealer, the auction fails, "but that's what they've been doing anyway," he added, noting that the last successful auction was Feb. 19. As of last week, the auction of the University's securities had reset at a failure rate of 6.243%.

Anderson said that the failure rate, which is set at the higher of either the one-month London Interbank Offered Rate or the double-A composite commercial paper rate, has been resetting every seven days since Lehman resigned, rather than the original 35-day resets.

Another school hit hard by the ARS crisis is Georgetown University, which last year tapped markets through the District of Columbia with six tranches of ARS totaling about $115 million that are now yielding either 10.5% or 15%, according to the Bloomberg data.

A source familiar with the school's finances said that university officials are "cautiously optimistic" they will be able to restructure their ARS into VRDOs sometime in mid-November. The VRDOs will be underwritten by Goldman, Sachs & Co. and PNC Capital Markets LLC, said the source, who asked not to be named because the plans are still tentative, particularly the timing, which is contingent on the VRDO market stabilizing.

VRDO rates peaked last month when investors spooked by the financial crisis overwhelmed several remarketing agents with requests to tender their VRDO holdings. As a result, the agents were forced to either increase the rates on the securities or put the VRDOs to the banks that provided liquidity facilities on the securities.

Constrained by balance sheet limitations, remarketing agents either were unable to carry, or had great difficulty in carrying, the securities on their books, as were many of the banks that have liquidity agreements.

Vickers noted that student loan lenders, who are some of the biggest issuers of ARS, are tightly constrained because Congress caps the return they can earn on the bulk of their student loans to the prevailing commercial paper rate plus 150 basis points.

The gap between what they are allowed to earn and the interest payments they are required to make on their ARS debt "is having a tremendous negative impact on nonprofit organizations," he said.

Vickers called on Congress to reconsider cuts in lender returns as well as increases in lender origination fees, both of which were implemented in legislation passed last year.

He also called on the Treasury Department to take actions that would lower the SIFMA swap index as well as Standard & Poor's J.J. Kenney Index, which is also used to determine some ARS failure rates. He said the Treasury could do this by bidding on VRDOS under its authority to purchase $700 billion of "troubled" securities.

"They need to step up to the plate and address these issues and they need to address them quickly," he said.

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