CHICAGO - The market for variable-rate demand obligations was calmer Friday after experiencing one of its rockiest weeks in recent memory, with weekly and daily remarketings failing for some outstanding issues and interest rates skyrocketing for others.
Turmoil in the large but opaque VRDO market comes nearly seven months after the upheaval in the auction-rate securities market. The ARS market collapsed in mid-February when firms that historically supported the auctions of the securities, but were under no contractual obligation to do so, stopping propping them up.
Spooked by the ongoing financial crisis last week, mutual fund managers and other investors overwhelmed several remarketing agents with requests to tender their VRDO holdings, Wall Street and other sources said Friday.
As a result, the remarketing agents were forced to either increase the rates on the securities or put the VRDOs to banks that provided letters of credit on the securities. Constrained by balance sheet limitations, remarking agents were by and large unable to carry the securities on their books.
While the ARS market was estimated at about $330 billion prior to its collapse, the VRDO market is much larger. A precise figure was not available Friday but sources said it included at least $400 billion of securities.
The turmoil in the VRDO market was evident in a spike of the weekly Securities Industry and Financial Market Association's municipal swap index to 5.15% on Wednesday from 1.79% Sept. 10. The index is based the yields of VRDOs.
Several bond attorneys gathered here last week for the National Association of Bond Lawyers' Bond Attorneys Workshop spent hours each day on conference calls with their clients, many of whom had recently converted from illiquid ARS into VRDOs that were thought to be much safer.
As with auction failures earlier this year, the interest rates on VRDOs spiked to double digits when their remarketings failed. That is because under the terms of VRDO agreements, failure rates are triggered when an LOC is called upon and the bank purchases the bonds.
Several attorneys said that their clients with VRDOs were paying failure rates as high as 12%, similar to the rates they paid when their ARS failed earlier this year.
Sources noted, however, that unlike the ARS collapse, the VRDO market remains liquid despite the strain caused by investors who sought to tender their holdings to raise cash to buy the safest possible investments, primarily short-term U.S. Treasury notes and bills.
"The net effect of the ARS crisis was that people got trapped," said one attorney who asked not to be named. "In the VRDO market, the pricing is wacky and there's lots of people trying to get out, but people are getting out and that's a major distinction."
Market sources said that there were several reasons for the spike in VRDO rates last week, but the primary driver was a spike in the rates of taxable mutual funds that in turn prompted tax-free funds to increase their rates to retain spooked investors.
Aside from the flight to safety by many fund investors, sources said that other factors that drove up VRDO rates last week included Lehman Brothers Holdings Inc.'s filing for bankruptcy, at least indirectly. The filing led the firm's broker-dealer unit to raise the rates on the VRDOs it marketed to get them out of its inventory, the sources said.
In addition, at least one Wall Street banker speculated that some investors of VRDOs stopped purchasing the securities to scale back their exposure to Bank of America and Merrill Lynch & Co., which underwrite some of the securities.
Market participants said Friday that the VRDO turmoil looked more like temporary volatility in a portion of the market that would soon return to normal, rather than the collapse of another corner of the market.
Some participants expressed optimism that a $50 billion plan by the Federal Reserve to insure the holdings of money market funds would have a calming effect on the market. At least two Wall Street sources said they believed that the news had already soothed investor concerns by Friday afternoon.
"Things are much calmer here today," said one short-term trader at a large Wall Street firm that remarkets VRDOs.
Meanwhile, NABL members recounted what they described as VRDO "horror stories" last week. Multiple attorneys described working for months to convert failed ARS into VRDOs, only to watch helplessly as the remarketings failed last week and the interest rates shot up.
One member said that his client, a southeastern city, had great difficulty firing its remarketing agent, a large regional bank-dealer that also provided the issuer with a letter of credit, when the bank-dealer declined to accept an offer from an underwriter to purchase all of the city's VRDOs at 3.5%. Consent from the LOC provider is required before an issuer is allowed to fire its remarketing agent.
The legal department of the bank-dealer told the city's staff and its bond counsel that the firm's policy is to only remarket VRDOs at their prevailing market rates, which were about 10.5%. Despite protests from city staff, the bank-dealer remarketed the securities at the 10.5% rate.
Only after the city's political leadership threatened to close its accounts with the local branch of bank-dealer did the firm relent and consent to its own firing as the remarketing agent. Under a different remarketing agent, the underwriter purchased the VRDOs at 3.5%.