CHICAGO - Turmoil in the faltering auction-rate market persisted yesterday as issuers continued to digest the results of mounting failed auctions of municipal securities, hastening their efforts to restructure their holdings amid surging interest rates.
The continuing struggle to draw sufficient investor interest in auction-rate securities has crossed a wide swath of credits - both strong and weaker. And it has prompted dire commentary from some market participants that the auction-rate security, as a municipal instrument, may be finished in the near-term at least as broker-dealers withhold their own capital to offset the loss of investor interest.
"It's done," said one health care investment banker. "This is gone. The whole security itself for at least the near term is flawed and damaged." Credits that otherwise may have a rating in the double-A category feel "demoralized" by the failed auctions, the banker added.
The auction-rate market encompasses between $325 billion to $360 billion of securities offered by leveraged closed end funds, corporate bonds, and municipal bonds. Student loans account for between $80 billion and $90 billion, and the leveraged closed-end fund side between $80 billion and $90 billion, according to a report from Moody's Investors Service where analysts are still calculating the size of the municipal piece.
While investors have demanded higher rates in recent months, in an unprecedented development absent an issuer's loss of its investment grade credit, auctions began to fail about three weeks ago, stunning municipal market participants. In the event of a failed auction, current holders retain the securities and the rates are set based on provisions included the deal's offering documents - a figure also sometimes limited by state securities statutes.
Asked if high interest rate resets of recent days would have a negative impact on New York's budget, Gov. Eliot Spitzer said: "This doesn't have a direct budgetary impact. The state of the auctions market securities and the concerns there will have a budgetary impact on some of the agencies whose interest payments will obviously jump . . . I think we will get that market stabilized one way or another in the very near term but it does demonstrate how volatile the market is and the need to address the underlying problems."
On Thursday, an immediate figure on the volume of failed auctions was not available by press time. On Wednesday, at least $10 billion or more failed. Sources said bonds with higher interest rate caps were the most successful at auction. One source familiar with the closed-end fund auctions said all but one series failed Thursday, though he did not have a dollar amount on auctions yesterday.
Several market sources said UBS AG, one of the largest broker-dealers for auction-rate securities, notified its brokers this week that the bank would no longer rescue auctions from failure. A firm representative declined to confirm the firm's position, but also did not contradict the assertion.
More precise information also emerged yesterday about failed auctions earlier in the week. More than $1 billion of auctions of New York City and New York state-backed debt failed on Wednesday. Out of thirteen auctions of state-backed debt totaling $867.2 million, only a single $104.5 million series issued by the Dormitory Authority of the State of New York succeeded.
The largest failed auction was $100 million of bonds issued by the Empire State Development Corp. issued in 2002 for correctional and youth services. Eight New York City auctions totaling $442.6 million failed on Wednesday while seven totaling $464.1 million did not fail. The highest interest rate reset was 12% for a failed New York City Municipal Water Finance Authority auction. Most reset rates were much lower.
Two Port Authority of New York and New Jersey auctions cleared on Wednesday, but at high reset rates. Versatile Structure Obligations series 7A in daily mode reset at 14.9% and Series 8C in weekly mode reset at 9% rate. This followed a failed auction on Tuesday of Versatile Structure Obligation Series 7C that reset at 20%. Information on auctions yesterday was not available at press time.
As issuers see their rates spike due to either a failed auction or lackluster interest, officials are looking at their restructuring options that include a conversion to another floating-rate mode or refunding to a fixed rate. But any restructuring can be mired in pitfalls depending on the terms of the original deal. Some bond documents limit an issuer's ability to convert and in some cases depending on a contract's terms, bond insurers hold sway over the ultimate decision.
In most cases when converting to a variable-rate demand obligation structure, issuers must shop around for a letter of credit or line of credit, both of which have spiked in costs as demand grows. Some providers have also hit their credit ceiling for writing new policies. "Given the credit crunch, there's a short list of banks providing LOCs whose credit themselves weren't damaged ... Their product is in great demand, and a scarcity of availability so logic would dictate that prices would go up," said Craig Underwood, president of Bond Logistix LLC.
Swapping to a fixed-rate may make sense for some stronger credits, but they still face increased overall costs of borrowing as issuers have already paid the insurance premiums. The common use of derivatives to synthetically fix auction-rate securities also can complicate a restructuring depending on the terms built into the swap contracts regarding mode conversions and refunding.
The situations of several Midwestern issuers present a snapshot of issuers' struggles across the nation. The two Michigan bond-issuing authorities that have the largest amount of auction-rate debt saw auctions fail earlier this week, as state officials worked to obtain liquidity that would enable them to restructure the debt.
The Michigan Higher Education Student Loan Authority, which carries about $2 billion in outstanding auction-rate debt, had two auctions fail this week, and the Michigan Bond Authority saw an auction fail Wednesday, said deputy state treasurer Tom Saxon. Auction-rate securities account for nearly all of the loan authority's debt portfolio.
The MBA has outstanding roughly $500 million in auction-rate debt. MBIA Insurance Corp. insures the bonds. The underwriter on the transaction is Merrill Lynch & Co. A spokesman for Merrill Lynch said the firm will not comment on the status of its auction-rate securities. The bonds were issued in four $125 million auction-rate tranches, and it's unclear how much failed in Wednesday's auction.
Michigan officials working to refinance the $2 billion in higher education loan authority debt have been slowed by difficulties in obtaining liquidity support, said Saxton. The inability to restructure the debt has forced the state to cancel a $50 million student loan program called MI-Loan, he added.
Officials are also working to obtain bank letters of credit for the MBA debt, which Saxton predicts will be easier to obtain that the higher education authority. "I don't think we'll have a problem getting liquidity, but it's a day-to-day thing," Saxton said. "We're going as quick as we can."
Officials at the Indiana Finance Authority are also considering restructuring wide swaths of auction-rate debt in its portfolio. The IFA has issued about $870 million in outstanding auction-rate debt - about 12% of its total debt portfolio. The IFA has seen its interest rates reset as high as 15% on some debt, said public finance director Jennifer Alvey and on Tuesday a $70 million series failed at auction. The broker-dealer is Goldman Sachs & Co. Under its bond contracts, the rate adjusted up to 15%, she said.
Roughly $611 million in auction-rate debt that was issued to finance construction of the new Indianapolis Colts football stadium and a nearby convention center saw interest rates around 6% at a recent auction, Alvey said. That debt includes two swaps, with the stadium debt scheduled to be locked in a 4.231% starting in August, 2008, and the convention center series to be locked in at 4.556% starting in December 2010. Interest rates on a piece of $200 million of ARS issued under the state's transportation program rose to 10%, Alvey said. The IFA has another $70 million in state office building commission auction-rate bonds.
The IFA has asked rating agencies to assign new underlying ratings to any existing bond series that carry only enhanced ratings to pave the way toward restructuring the auction-rate securities. "If we decide to make changes to the way bonds are structured we can always fall back on our underlying ratings," Alvey said.
It's likely that more credits - especially health care credits - will seek new underlying ratings as the fallout in the auction-rate market continues, said one analyst. "I think what you're going to see is a greater demand for ratings," said Fitch Ratings health care analyst Jim LeBuhn in a recent interview. "Even for those who decide to go insured, what I expect is that borrowers will have some comfort knowing further dislocation in insurance to have an underlying published rating provides some base level of credit quality that investors can look at."
Beloit Memorial Hospital in Wisconsin yesterday received an upgrade on $41 million of auction-rate securities issued through the Illinois Finance Authority and $10 million through the Wisconsin Health and Educational Facilities Authority due to new bank support. The borrower restructured its debt to a daily variable-rate mode and included a LOC from JPMorgan Chase Bank NA. The bonds will continue to carry insurance from Radian Asset Assurance Inc.
Puerto Rico saw $63 million of auction-rate securities have a failed auction Tuesday and reset to 12%, the security's ceiling. Goldman Sachs & Co. ran the failed auction and the debt is insured by CIFG Assurance North America Inc. The following day, $50 million of GO debt reset at 10.8% in a Lehman Brothers auction with bonds insured by Financial Guaranty Insurance
California's Bay Area Toll Authority is one issuer that has benefited from a limited interest rate hike built into its deals. The authority has $2.9 billion in variable-rate debt in its $5.4 billion portfolio, said chief financial officer Brian Mayhew, including more than $700 million in auction-rate securities.
Auctions of BATA auction rate securities are failing, Mayhew said, but the agency's bond documents cap in the event of a failed auction is tied to LIBOR, resulting in rates under 5% at the moment, he said.
The problems are not limited to auction-rate securities, he said - the VRDOs are also problematic. Those carrying insurance from XL Capital Assurance Inc., for example, are no longer eligible for money market accounts. Mayhew said BATA staff and consultants are weighing their options to respond to the crisis, including refinancing the entire variable-rate portfolio, but he said for now he is waiting as the use of floating rate has served the authority well so far in its efforts to finance construction or rehabilitation of seven toll bridges without raising tolls. BATA has hedged much of its variable-rate debt, effectively reducing its real interest costs, Mayhew said. "It's a good portfolio. I'd hate to waste it."
Auction-rate securities were favored by a wide range of typically stronger credits in recent years. While their interest rates fall in line with variable rate demand bonds, the borrower saves on other issuance costs. Without the "put" risk for issuers that allows holders to return the securities to their issuers as other floating rate securities carry, no liquidity provider is needed and there's no need to maintain a short-term rating as the securities are considered long-term debt. The securities also typically include provisions that allow for the debt to called at par and converted to fixed-rate or another form of floating rate.
The primary investors in auction-rate securities include corporate cash managers and high net-worth individuals and in some cases intermediate bond funds. Money market funds are prohibited from purchasing the securities because they lack a tender option.
After an initial auction, the securities are reset at intervals of 7, 28, or 35 days through a Dutch auction process. The broker-dealer on the issue typically seeks bids and will in some case to help the auction run smoothly offer its own bids. Once complete, the bids are submitted to an auction agent who in turn sets the new rate based on orders
The routine process has veered in recent months as investors began to shun the securities - a move that reflected worries over a lack of liquidity and concerns over the deteriorating credit stability of the monoline credit insurers - due to their backing of various subprime securities. A good chunk of the auction-rate securities market carries insurance. And, where issuers once could depend on their broker-dealer to serve as a backstop in the event of a failed auction, many investment banks are now withholding their own capital as they struggle with losses tied to their holding of subprime mortgage securities.
Michelle Kaske, Ted Phillips, and Rich Saskal contributed to this story
