Sell Side

Hurdles Remain as Market Navigates ARS Crisis

MIAMI BEACH, Fla. - As the market grinds its way through the auction-rate securities crisis and issuers continue to convert or refund ARS into variable-rate demand obligations, hurdles remain.

Estimates to date claim that about one third of outstanding ARS debt has been refunded or converted.

At the annual conference of the National Federation of Municipal Analysts, JPMorgan managing director Thomas Ryan said the bank had converted about a third of the ARS it has underwritten, while the Wall Street Journal has reported that Merrill Lynch chief executive officer John Thain said his bank has refinanced about a quarter of its ARS.

But for issuers, many potential obstacles remain. As the bond insurers begin to report their first quarter earnings, the trend in the market over the last month to find solutions to keep the existing insurance policy intact on ARS conversions may be tested.

Ambac Financial Group, the first to report earnings this month, announced a first quarter loss of $1.7 billion. As a result many people have given up on that firm's insurance, said Adam Rudner, a director at Citi, who spoke on the same panel with Ryan.

"People were holding out on Ambac, but with the earnings report they are just getting out of Ambac paper," Rudner said. "A lot of the issuers want to keep the insurance they paid for, but often the best course of action is to get rid of the insurer."

In addition, letter of credit banks are increasingly reluctant to work on deals with insurance from Ambac, MBIA Insurance Corp., or any of the other maligned bond insurers. In many cases, the bond insurers retain ultimate control over the payment options if there is a default or non-payment on the bonds.

"Banks wants to be first in line," Rudner said. "They don't want to take risks to these insurers."

This has made it even more difficult to secure liquidity facilities and other credit enhancements for issuers looking to convert out of ARS, the analysts said.

It is also becoming more difficult to get VRDB deals placed with tax-exempt money market funds, as the supply of LOC-wrapped variable-rate bonds overwhelms the demand. As money market funds reach capacity in the amount of exposure they can take to certain LOC providers, they are having to pass on deals.

"We're passing on some of those deals because we are just saturated," said Kevin Shaughnessy, a portfolio manager at Charles Schwab Investment Management. "This is the biggest challenge facing money market funds."

His funds, with more than $36 billion in assets under management, are overweight in the large LOC banks like JPMorganChaseBank or Bank of America NA. While some French banks like BNP Paribas have gotten more involved, Japanese banks have been slow to enter the market and many money market funds have strict limitations on how much exposure they can take to German banks, Shaughnessy said.

As a result, Charles Schwab and other money market funds are snapping up VRDBs from issuers with strong balance sheets that do not need letters of credit.

"To the extent that you have strong issuers, that is where money funds are going to move," Shaughnessy said. "You get the benefit of the diversification and don't run up into any bank limits."

In some cases, those deals are so oversold they are selling at spreads 10 or 15 basis points below the Securities Industry and Financial Markets Association rate, he said.

Despite these struggles, auction-rate issues are starting to clear at lower levels - including programs for California and Massachusetts - indicating that the market may be normalizing, the panelists said.

According to the Wall Street Journal, Merrill's Thain expects 100% of the bank's ARS will be refinanced within the next 12 months. However, JPMorgan's Ryan told the NFMA conference attendees that he believes some ARS may remain outstanding.

If institutional investors and sophisticated retail players get a premium for having less liquidity than VRDBs, they may stay in the market. The SIFMA index plus a spread of about 50 basis points could be a possible clearing threshold, Ryan said.



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