Failing auctions of auction-rate securities could have a long-term negative impact on the ratings of certain public finance issuers and student loan-backed securitizations, if the current market turmoil continues, Moody's Investors Service said in a report released yesterday.
If broker-dealers don't offer liquidity as the "buyers of last resort" as they had in the past, Moody's expects additional auction failures in the coming "days, weeks, and perhaps even months." A prolonged period of market disruption that could lead to potential downgrades would be "measured in months rather than weeks" said Moody's analyst Bill Fitzpatrick.
Fitzpatrick said it was difficult to generalize how failed auctions could affect issuers because of the wide variety of types of credits - from state governements to nonprofit hospitals, for example - as well as the different maximum rates that failed auctions reset at depending on the offering documents.
"The primary factor that is potentially material for municpal issuers is the increased interest expense," Fitzpatrick said. "Simply having to carry those kinds of rates that you've read about for an indefinite length of time. Factors would include how long they do have to carry it, what the reset is."
For example, the interest rate was reset at 20% at a failed auction of some Port Authority of New York and New Jersey ARS last week - that reset this week to 8%. Rates have also reset much lower on other securities compared to the Port Authority's depending on what was set forth in the offering documents such as a rate set to a benchmark such as the London Interbank Offered Rate.
"One mitigating ciricumstance today is the interest rates are generally low," Fitzpatrick said.
The failures are "occurring in spite of the fact that the underlying credit quality of issuers remains strong in the short-term even as interest expenses spike up."
While many issuers can manage higher interest rate resets that result from failed auctions, others may have trouble.
"There may be some issuers with more narrow operating margins that will experience rising budgetary stress if the high rates persist for the medium or long term," the report stated. Issuers often did not budget for higher interest rate costs because they expected that interest rate swaps would hedge interest rate risk. Rising spreads above benchmarks can add to costs because the swap payments are tied to the benchmark and not the market spreads which have increased, according to the report.
The rise in failed auctions has come from banks' reluctance to provide market liquidity support, which Moody's attributes to increased aversion to exposure to risk in the face of a credit crunch.
"Investors are now realizing that ARS are in fact long-term securities with inherent price risk and liquidity risk," the report stated. "Auction intervention on the part of the broker-dealers may have masked these risks."
Bonds sold by public finance issuers in auction-rate mode account for about half, $165.5 billion, of the estimated $328 billion auction-rate market. Only 13 auctions failed from 1984 to 2006, but in the last two quarters of 2007, about 31 auctions failed and 32 more failed in the last two weeks of January, 2008, the report said.
The report came out as auctions in New York continued to fail this week, inlcuding nine auctions of state-backed debt.