The problems in the auction-rate market continue to give birth to creative solutions: issuers are refinancing or restructuring, Wall Street firms have allowed investors to borrow against their holdings, and several other market players have attempted to form a secondary market.
Though beset with problems, a secondary market could introduce needed liquidity into the market.
At least four firms now host trades for auction-rate securities - MuniCenter LLC, Restricted Securities Trading Network, Chapdelaine & Co., and Hartfield, Titus & Donnelly LLC's online system. Tradeweb and BondDesk Trading, two other popular platforms, do not offer ARS on their systems.
"There are many issues involved in trying to facilitate a marketplace that is currently dysfunctional," said Tony Miscimarra, president of BondDesk Trading. "Thus far, providing [solutions] has been challenging considering some of the obstacles to creating a secondary market within an uncertain market for the future of ARS."
When the market functioned, investors looking to rid themselves of auction-rate securities had only to wait until the next scheduled auction, or in some cases sell the ARS back to the broker-dealer between auctions. There was no need for a secondary market.
However, as the credit crunch deepened many of the broker-dealers deserted the market, choosing not to stand behind the auctions as they had done before. Auctions began to fail, as there were not sufficient buyers to make sellers, leaving ARS holders with no outlet to sell their investments. Seeking to tap this market, a number of outlets worked quickly to set up systems where ARS could be traded.
"When the ARS mess started, it was suggested to us that we take a look at it and consider getting involved," said Barry Silbert, chief executive officer for Restricted Stock Partners, the company that runs Restricted Securities Trading Network.
Silbert spent a week talking to various market participants and at the beginning of March unveiled a platform function to offer and bid on ARS, starting with auction-rate preferred securities - issued by closed-end mutual funds - and then moving to student loan ARS, then municipal ARS.
Several hundred institutions - including multi-strategy and distressed debt hedge funds, high-yield bond funds, issuers, and sovereign funds - have signed up with the system to bid on municipal ARS, Silbert said. Since March, about 170 ARS have been listed on the platform, with about five to seven transactions occurring each day, Silbert said. He charges a 1% fee for each side and handles the entire closing and settlement agreements for the transaction.
"The early activity was sparse," he said. "The holders were looking for par or close to par and the buyers were looking for heavy discounts."
Hartfield Titus has been working on updates to its web-based platform for about six weeks, with the ARS function as an added part of the existing system. And though there are now a number of listings, not a single trade has occurred.
"There is caution in the wind in terms of how do we go forward," said Jay Caldas, HTD's vice president. "How do we get the secondary market off the ground?"
Chief among the issues is the bidding rights attached to the securities. These rights essentially ensure that the holder of the ARS has a right to participate in the next auction. However, since ARS were never intended to change hands, the concept of transferring the bidding rights was never considered, Silbert said.
In addition, it has proven difficult to get comprehensive information for the securities. The short-term nature of the long-term maturities of ARS makes the life of the loan difficult to determine and maximum rates are often complex calculations, making appropriate disclosure a necessity. However, trustee banks have balked at requests to disclose the information they hold for each issuer.
In a recent conference call hosted by the Securities Industry and Financial Markets Association, representatives of some of the banks said they worried about the legal liability in disclosing that information, according to a person on the call.
A third risk involves the possibility that municipal issuers may refinance outstanding auction rates. In one example, Hartfield Titus had an offering on its platform of 92 for a $20 million block of ARS from a Mississippi issuer. A couple of days after the bonds were offered on the system, the issuer refinanced them. Though the trade never went through, a seller could unnecessarily lose money if he were to sell at a discount prior to a refunding.
"It is a treacherous market for the sell side," Caldas said. "You don't want to be on that side."
And it remains to be seen how platforms will arrive at the best trade execution. Municipal ARS are selling at a discount, but because the bid and offer spreads are so wide it is difficult to get an accurate value of these securities. For the most part, muni ARS are fetching a price that is roughly 1% to 10% below par, Silbert said.
A Trimble County, Ken., issue for sale on the Hartfield Titus system was being offered earlier this week at 96. As of yesterday, the highest bid was 94, with neither party looking to give any ground. The bonds have a 35-day reset, are insured by Ambac Assurance Corp. and underwritten by JPMorgan.
Wall Street firms are still undecided on the price of these securities as well, with UBS AG beginning to mark client holdings at a discount while other firms continue to insist the securities should be valued at par. Valuation services like Pluris Valuation Advisors, which works closely with Restricted Stock Partners, and Duff & Phelps certainly help, but pricing remains difficult.
"There is a market so we have some indication of what a buyer would pay," said Espen Robak, president of Pluris. "But it can only help valuations if this market becomes more liquid."
The success of these secondary market ARS trading platforms will ultimately depend on how well the problems are addressed, or how the overall market adapts, said Cecilia Gondor of Thomas J. Herzfeld Advisors. UBS announced last week that it will make loans to investors for 100% of their ARS holdings, while other firms have offered similar loans aimed at providing liquidity.
"A sale in the secondary market would in effect crystallize a loss," according to a recent report by Prashant Bhatia, an analyst with Citi, who also said the ARS market would cease to exist. "This may be an option for some clients who need liquidity immediately and are unwilling to take a loan out. With some brokers already marking down these securities on client statements, this may be right around the corner."
