Auctions of municipal auction-rate securities totaling as much as $10 billion in par value have failed since Monday. A market source estimated that broker-dealers buying up excess auction-rate securities accounted for 10% to 20% of the market.
Over the past three weeks, Wall Street's biggest banks have seen their auctions fail, including, Piper Jaffrey & Co, Stifel Nicolaus & Co., Goldman Sachs, JPMorgan, Citi, Morgan Stanley, Bank of America, Merrill Lynch & Co., Wachovia Bank NA, and UBS. Just yesterday six of the banks saw failed auctions.
"We have seen widening spreads, reduced demand for certain auction-rate securities and failed auctions, including some auctions which Citi acted as broker dealer," Citi said in a statement.
Lehman Brothers, UBS, and Goldman Sachs declined to comment. Credit Suisse, RBC Capital Markets, and Deutsche Bank did not return calls for comment.
Auction-rate securities are short-term debt instruments with a long-dated maturity, which reset every 7, 28, or 35 days through an auction process. In a properly functioning auction, a broker-dealer will go out and seek bids from both current and perspective auction rate investors, and after those bids have been received an agent will set the new rate.
Over the last few months, the rate resets have moved progressively higher as investors began to shy away from holding the securities. Their fear was based largely on liquidity concerns, exhibited through a number of factors such as the lack of a put feature, the quality of the insurance wrapping the ARS, a low maximum rate of return mandated by the contract, and the ability or willingness of the broker-dealers to support or backstop the auction.
As the bond insurers, including Ambac Assurance Corp. and MBIA Insurance Corp., have suffered downgrades leveled by the rating agencies, investors have become uncomfortable with the safety of the attached guarantee.
Ambac was the number one insurer of auction rate deals between 2000 and 2007, insuring 33.2% of the entire market, or 583 deals with a value of $50.8 billion. MBIA was the second busiest financial guarantor during the same time period, insuring 345 deals for $28.5 billion in deals.
A key aspect of ARS is that they do not contain a "put" component, in which holders are able to send the securities back to the issuer. While this frees the issuer from having to secure bank liquidity, it also means that in some cases investors are left holding onto the ARS for longer than they would like due to lack of liquidity in the market.
"The market is very, very troubled right now," said John Bonow, managing director with Public Financial Management Inc., in Seattle. "It's very hard to generalize which programs are most at risk. That being said, the product itself is not being received well right now by investors due to their illiquidity fears."
From 2000 to 2007, PFM was the busiest financial advisor in respect to auction rate deals, advising on 296 issues for par value of $24.8 billion, or 10.1% of the market.
Auction rate securities generally draw three types of investors: high net worth retail investors, corporate accounts looking for places to park their cash on a short term basis, and in some cases, intermediate bond funds. In many cases, market sources say that retail investors are still involved in the market and that it is the corporate investors that are suddenly unwilling to hold those securities.
"The more corporate investors have a different approach or feel they cannot tolerate the risk of holding the paper for a long period of time," Bonow said. "Those investors have been submitting a lot of sell orders lately."
The risk of having to hold paper for a longer duration is a reality. In January, Bristol-Myers Squibb Co. announced a $275 million writedown of its auction-rate security holdings because it could not sell the holdings. Last year, Logitech International SA also announced a material impairment related to the auction rate securities it held, said Jeff Glenzer, managing director of product development at the Association of Financial Professionals.
According to the AFP - which surveyed firms of annual revenue with between $1 billion and $5 billion for a "liquidity survey" it held last summer - one third of all the surveyed companies were allowed to hold auction-rate securities as an investment for cash holdings.
Of the companies surveyed, 5.1% of the par value were held in auction-rate securities.
Investors forced to hold the ARS for longer than they would like are compensated with an increase in rates. In cases where the auction is successful but features less demand, rates increase relatively slowly.
For auctions that fail, the rate for those left holding ARS is set either through the contract associated with the deal, or through a rate that is set by statute.
"In almost all states there is a statutory maximum, be it, 12%, 15% or some other percent," Bonow said. "Many auction rate programs default to that rate through state law, but there are a number of programs that have formulaic max rates, some of which aren't particularly high right now."
Bonow said he and his colleagues have been told by broker-dealers that it is those programs with the relatively low maximum rates - even if they feature issuers that are highly rated - are being allowed to fail.
"Investors are stuck and that is part of the risk but they are stuck at a pretty low max rate, which they find unpalatable," Bonow said. "Those that are failing are doing so because of this low max rate, rather than the insurer or credit concerns."
In other cases, issuers are looking to get out of auction-rate securities, choosing instead to convert them to variable rate demand notes, or refund the auction rates to then issue either fixed rate long-term bonds, or VRDNs. However, many potential pitfalls exist in these options often making it difficult for issuers to get out of their programs.
Going forward, there is some question as to whether the auction rate market will continue to exist. Arthur Korsun, director at Calyon Corporate and Investment Bank, believes that as soon as the excess liquidity in the market is mopped up - the 10% to 20% of the ARS that had been bought by banks - rates will come back down. This may drive some of the larger issuers from the market, but it will continue as an option for the smaller insurers, Korsun said.
However, Glenzer, said his organization's members will think long and hard before heading back into a market short on liquidity, despite the promise of higher returns.
"I think our members will be very suspicious when anyone comes to them with an investment idea that positions more return without the risk," Glenzer said. "That will be a long-term impact." q
