Beyond the ARS Collapse

WASHINGTON - More than a year after the auction-rate securities market collapsed, some $78 billion of illiquid municipal ARS remain outstanding, but a growing number of bond attorneys are pushing to use a new type of taxable bond program recently authorized by Congress to refund some of those securities.

The bond attorneys plan to prod Treasury Department and Internal Revenue Service officials expected to speak at the National Association of Bond Lawyers' Tax and Securities Law Institute in Orlando tomorrow and Friday to provide guidance that will allow them to use the Build America bonds that were authorized by the economic stimulus bill for ARS refundings.

Under the program, state and local governments can issue an unlimited amount of taxable Build America bonds in 2009 and 2010, and the issuer either elects to receive a cash subsidy from the federal government or to have it provide the bondholders with a tax credit. The bond proceeds must be used to finance capital expenditures, minus issuance costs and a reserve fund.

Build America bonds can only be used by governmental issuers, and not the nonprofits or student loan lenders that also sold ARS. However, they would still provide widespread help to many issuers that have not been able to find or afford liquidity facilities to refinance their ARS into variable-rate demand obligations, the bond lawyers said.

"If Treasury would make it clear that the taxable bond option with the issuer subsidy is available for refundings - and not just new money - it would really help people refinance their auction-rate debt," said J. Hobson Presley of Presley Burton & Collier LLC in Birmingham.

Another bond attorney who did not want to be identified noted that the legislation's intent is ambiguous and would need to be clarified.

"Legally there's a good argument that a refunding would be okay if the old bond financed capital expenditures," the attorney said. "It does not say the capital expenditures must be incurred on a specific date or after a specific date. But unlike other areas where you can have a very good legal argument and give an opinion on it, this is one where essentially the IRS will be signing off on the deals."

The attorney added: "If you're doing a refunding with Build America bonds, the coordination with the IRS would make it very difficult to do a refunding unless there was clear guidance on the issue."

Presley and other attorneys said if the Treasury does not believe it has the authority to interpret the stimulus bill to allow the refundings, they hope Congress will revisit the issue in a future bill that addresses technical changes to the stimulus legislation.

David Caprera, of Kutak Rock LLC in Denver, complained that the stimulus bill is maddeningly imprecise in its language and Congress would almost certainly need to draft technical fixes to clarify portions of it, regardless of what is included in Treasury's guidance on the taxable bond program.

He noted, for instance, that the bill uses the terms "bonds," "issue," and "obligations" as if they were interchangeable, without realizing that they could be interpreted differently and could give rise to meanings other than those intended.

"The act is perhaps one of the most poorly written pieces of legislation that we've seen in some time ... because the objective was to get it out as fast as it could be written and they did not have the time to take the care that one would normally see in drafting technical tax legislation," he said.

Though Caprera said that Treasury has been "extremely responsive" to requests from the municipal market, "it may be very difficult for Treasury and IRS to interpret the word 'used' for refinancings."

Anne Phillips Ogilby, a partner at Ropes & Gray LLP in Boston, said that some of her clients, which include public hospitals, would jump at the chance to refund their ARS with taxable bonds that have a lower overall cost. But, she said, the program does not guarantee muni issuers access to the taxable market, and it's not yet clear if the Build America bond program offers a lower-cost financing vehicle for traditionally tax-exempt debt.

"We'll take any help we can get in this truly horrible environment," Ogilby said. "But we don't yet know if this will be a huge shot in the arm because it's not clear if this tax credit approach will price better than the customary market."

John Cross 3d, tax legislative counsel for the Treasury Department's office of tax policy, is speaking at NABL tomorrow. Neither Cross nor spokespersons for the House Ways and Means and Senate Finance committees, could be reached for comment.


About $78 billion of municipal auction-rate securities remains outstanding, according to the Municipal Securities Rulemaking Board.

The Regional Bond Dealers Association estimates that some $100 billion of municipal ARS were restructured or refunded since the market collapsed last year. In addition, the group estimates that some $85 billion of student loan ARS remains outstanding, about the same level before the market collapse."

Most market participants believe the ARS market is dead.

"It's difficult to see the auction market coming back," said Roger Davis, head of public finance at Orrick, Herrington & Sutcliffe LLP.

But some state and local issuers - particularly smaller ones with weak credits that are unable to find reasonably priced liquidity facilities from banks - are unable to convert their ARS into other short-term securities.

As a result, several market participants have been pushing the federal government to step in to provide liquidity to issuers trying to convert ARS to variable-rate demand notes or sell new VRDNs.

"The broad question is, what kind of solutions are there for issuers to be able to borrow at the short end of the curve?" asked Michael Decker, co-chief executive officer of RBDA. "Finding a way to restart the VRDN market is I think the most viable option. But in the near term, I don't think we can rely solely on banks to provide liquidity facilities to that product."

In October, RBDA and the Education Finance Counsel, a Washington group that represents nonprofit student loan lenders, formally asked Treasury to create such a liquidity backstop.

Though Treasury officials have not ruled out the possibility, they have been without key staff since President Obama took office and remain focused on recapitalizing financial institutions. However, the Obama transition team said in early January that it plans to create some type of backstop for municipal securities.

As market participants push for these solutions, the need to help municipal issuers is gaining attention and support of federal lawmakers. Members of the Senate Banking Committee have been pushing the Federal Reserve to expand its lending programs to include muni issuers.

"The financial crisis has left the credit markets for state, county, and local governments frozen or seriously impaired," Sen. Michael Bennet, D-Colo., said Monday. "Banks receiving [Troubled Asset Relief Program] money, nonetheless, remain on the sidelines, unwilling to venture back into these markets. It is the Fed's statutory mandate not to sit on its hands and allow these bond markets to collapse, dragging down the credibility of state and local governments in its wake."


The auction-rate market grew significantly during this decade, to a high of $42.2 billion of new issues in 2004 from $7.7 billion in 2000. Even though overall issuance more than doubled between 2000 and 2007, auction-rate securities comprised more than 9% of the new-issue market in 2007 compared to 3.8% in 2000.

As long as the auctions always functioned, brokers marketed the securities as cash-like investments that earned a reasonable interest rate. Issuers liked the instruments because they could come to market with long-term paper at short-term rates, sometimes even using a swap to lock in a low fixed rate.

The market, though, depended heavily on bond insurance, because investors relied on the guarantors' ratings rather than those on the underlying credits themselves. When bond insurers' financial positions began to deteriorate in the fall of 2007 as a result of subprime mortgage exposure, the rates some issuers paid at the auctions began to rise.

But the fatal blow came last February, when broker-dealers that ran the auctions stopped stepping in to keep them from failing. With investors souring on bond insurance and no support from the brokers, billions of dollars worth of auctions failed.

The failed auctions meant some issuers paid penalty rates as high as 20% and that investors who thought their holdings were as good as cash got stuck with illiquid paper.


Data from the initial phase of an ARS transparency system that the MSRB rolled out in January reveals at least three different types of illiquid ARS: those that have high maximum rates, those that have rates are pegged to indexes that are at historic lows, and those backed by student loans that have restrictions on maximum rates.

For most of last year until mid-September, Reno, Nev., paid a range of rates that rose as high as 14.95% on $73 million of ARS that it sold in October 2005 as part of an $89 million transaction. When the capital market froze in September after the bankruptcy of Lehman Brothers Holdings Co., auctions began to fail and the city paid a 15% penalty rate until it was able to restructure the bonds into VRDOs on Feb. 5.

Attempts to restructure the securities earlier proved difficult. Though Reno obtained an LOC from U.S. Bank at the end of June, by the time the city had completed complex negotiations to drop insurance on the ARS series from Financial Guaranty Insurance Corp., the bonds' guarantor, the revenue backing the bonds had declined and U.S. Bank withdrew. It took another two months for the city to line up a new LOC provider - Bank of America - and to close on the conversion to VRDOs.

"It was one of the most difficult transactions I've ever worked on," said Andrew Artusa, managing director for NSB Public Finance in Las Vegas, Reno's financial adviser.

But for many of the ARS that have not been restructured, failing auctions are less painful because their maximum rates are linked to either the London Interbank Offered Rate or the SIFMA Municipal Swap Index, both of which are at near all-time lows. The municipal swap index stood at 0.67% on Feb. 25.

Many issuers have decided to stick with those index-linked penalty rates, at least for now, given the difficulties obtaining liquidity facilities and the constrained market for long-term debt, especially for all but the highest quality issuers, market participants said.

Meanwhile, student loan lenders, many of whom sold ARS backed by the student loans they originated, have also been hit with consistently failing auctions. But in a unique wrinkle to the ARS market, the maximum rates on their illiquid securities were structured to fluctuate between a high numerical figure and zero because the interest on their bonds was not allowed to exceed the revenue the lender received on its loans.

Don Vickers, president of Vermont Student Assistance Corp., has spent the past year juggling a mostly illiquid pool of $1.7 billion of student loan ARS. Last May, he was able to refinance about $300 million, or 18% of his portfolio. The challenge to refinancing remains liquidity, he said.

Banks, suffering from their own capital troubles, have been unwilling to provide the liquidity backstop necessary to convert ARS to variable-rate debt.

"Letters of credit have gotten expensive because they've gotten scarce," Vickers said.

He also noted that some student loan bonds have been downgraded as rating agencies have required issuers to over-collateralize deals by 5% to 7% in addition to the cost of issuance, even though most of the loans were originated through the Federal Family Education Loan program and are 97% federally guaranteed.


Although the collapse of the auction-rate market has affected a number of issuers, health care was hit particularly hard. Issuers in that sector had been some of the biggest users of ARS. Their troubles come on top of many of the economic factors putting pressure on health care providers, such as a rise in the number of uninsured patients and likely lower Medicare reimbursements from cash-strapped states.

"It's been a game-changing event in a pretty big way," said Kenneth Kaufman, managing partner financial adviser Kaufman Hall & Associates Inc. "As a matter of fact you probably can't overestimate the problems that it's caused. Many health care organizations had very sophisticated capital structures that were based on a combination of variable- and fixed-rate debt."

Hospitals were among the first issuers that decided to bid on their own auctions. Although the legality of this was uncertain at first, the IRS and Securities and Exchange Commission both gave approval to it following the auction-rate collapse last year, as long as the bids were disclosed in advance.

Virginia's Rockingham Memorial Hospital bids every week on the $50 million of its ARS that are still outstanding, which cleared at 0.66% on Feb. 24. Following the most recent auction, it holds $46.8 million of the bonds.

After bidding above the SIFMA municipal swap index on its early auctions, the hospital now bids the SIFMA index rate on the bonds after determining the market did not adjust its bids to reflect what the hospital was doing. The hospital uses a Libor-based line of credit to fund the purchases, according to senior vice president and chief financial officer Mike King.

Despite the occasional spike, the cost of funds on the $50 million portion of debt has been lower over the past 12 months than in the year preceding the auction-rate collapse, because Libor and SIFMA are so low, King said. The hospital could afford to pay off the debt, but prefers to hold onto the cash for now, he said. Rockingham currently building a $280 million hospital, which is on schedule to open in 2010.

"We have been waiting and watching, trying to decide when is the best time to do something different," King said. "The VRDO market stabilized for a while, then went nuts for a while, and now seems to have stabilized again. But I tend to be pretty conservative. We're very fortunate to be financially stronger than a lot of the other institutions that hit kind of a turbulent market."

Some issuers managed to get letters of credit and convert their debt. Even though its auctions never failed, South Dakota-based Avera Health entered the market with three transactions totaling $250.5 million in June, part of which refunded all its ARS debt.

It addition to replacing $120 million of ARS insured by Ambac Assurance Corp., Avera also refunded $50 million of VRDBs backed by MBIA Insurance Co. Of the new bonds that were variable rate, it received LOCs from both US Bank NA and Allied Irish Bank Plc.

Last February, the rates on Avera's auction-rate securities spiked to around 5.75% before dropping to as low as 3% by June. But despite a brief scare during September when the rates on all VRDOs spiked, the new variable-rate bonds have traded lower than ever. Recently, Avera has paid around just 0.50%.

"We just feel fortunate," said Jim Breckenridge, Avera's senior vice president of finance. "I think it was just a stroke of luck that we got into the market when we did .... It wasn't too long after that liquidity dried up, and we had already got locked up for three and five years."

But many issuers are not as lucky. Given the troubles banks are having, liquidity facilities are even more difficult to obtain than following the auction-rate collapse. In addition, money market funds are running out of the capacity to hold paper backed by Berkshire Hathaway Assurance Corp., Financial Security Assurance Inc.-, and Assured Guaranty Corp., according to George Friedlander, managed director and fixed-income strategist at Citi.

The market for short-term paper is based solely on the supply - or in this case, the lack of it, he said. The market can always absorb more paper by raising yields, but right now there is a "severe shortage" of variable-rate paper available for the funds to purchase.

"It creates a sad irony for issuers," Friedlander said. "You have an extraordinarily low-yielding variable-rate market that they can't access."


The collapse of the ARS market, -which left investors stuck with illiquid securities that they had been assured were cash-like - prompted the filing of thousands of complaints with state and federal securities regulators.

Investigations by the regulators revealed that broker-dealer firms had misled their clients about the liquidity and safety of ARS. They showed that in some cases brokers were still pushing ARS to clients while firm executives sold their ARS holdings.

A year after the collapse of the market, some 23 firms have agreed to buy back ARS, either independently or as part of settlement agreements with state and federal regulators. States and the federal government returned a total of at least $55.5 billion of liquidity to investors and the states collected at least $165 million in fines.

The SEC's enforcement division finalized settlements with Citigroup Global Markets Inc. and UBS AG - the largest underwriters of the securities, comprising 40.2% of the market - that provided $30 billion of liquidity to investors. It also reached preliminary settlements with Bank of America, Merrill Lynch & Co., RBC Capital Markets Corp., and Wachovia Securities LLC.

SEC officials repeatedly hailed the settlements as the largest in the commission's history. Though there were no penalties in the settlements, the SEC has reserved the right to assess penalties at a later date, based largely on the firms' compliance with the requirements of the settlements.

An attorney who did not want to be identified said that the settlements are "historical," not only for the sheer dollar amount involved but also for the type of remedy that has been provided to investors. In previous enforcement actions - particularly in cases tied to Enron and MCI Worldcom - investors only received pennies on the dollar from their investments. But the investors in auction-rate securities received all of their money back.

"The money isn't illusory," the attorney said. "This is very unique."

Meanwhile, both state and federal regulators say they are continuing their probes and have not ruled out enforcement action against more individual dealers.

Members of a coalition of states from the North American Securities Administrators Association, which formed in April to investigate firms for ARS sales practices, say they are continuing probes against firms not involved in the settlements. The Financial Industry Regulatory Association continues to investigate 24 firms, according to spokesman Herb Perone.

State regulators also said they are continuing to investigate "downstream firm" - brokerages that sold, but did not underwrite, ARS. Fidelity Investments is the only brokerage firm to have announced a buyback program. But Charles Schwab & Co., TD Ameritrade, E*Trade Financial, and Oppenheimer & Co. have been subpoenaed by New York Attorney General Andrew Cuomo.

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