Auction Rate Securities
Auction Rate Bond Market Faces Uncertain Future
Auction rate securities (ARS), investments once considered as safe as cash, are the latest victim in the fallout of the subprime mortgage collapse.
Auction-rate securities are long-term corporate bonds, municipal bonds and preferred stock on which the interest rates are reset periodically — typically every seven, 14, 28 or 35 days — based on bids submitted through securities firms.
In the past, auction-rate securities have been popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other not-for-profit entities because of their low financing costs and the fact there are usually fewer parties involved in the financing process and no requirements for third-party bank support.
Holders of auction-rates securities are allowed to sell them on the days in which the interest rates have been reset. The problem now is finding buyers, as the $330 billion auction-rate securities market experiences turmoil and uncertainty like never before.
Historically, auction-bond failures are rare. But in recent weeks, increasing concern regarding the credit strength of insurers backing the underlying debt obligations has led to a rapid decline in demand for the securities. Adding more fuel to the fire is the reluctance of banks like UBS, Citigroup and Goldman Sachs to submit bids in fear they could be at risk of holding too many bonds.
As reported in a Feb. 13, 2008, article by Martin Braun on Bloomberg.com, nearly half of the $20 billion in securities that went up for auction on Feb. 12 failed to generate interest among bidders. As result, no securities were sold. Merrill Lynch has gone on record that it plans to reduce purchases of any auction-rate securities that fail to attract enough bids from investors. UBS goes one step further — it will not buy the securities, period.
Why the failure?
The failure of the auctions can be traced to investor concerns about the credit ratings of the bond insurers that back the securities. When an auction fails, issuers are forced to abandon their offerings. Or, they have to pay exorbitant interest rates, which is exactly what the Port Authority of New York and New Jersey recently had to do.
Although the interest rate on the $100 million of bonds that the Port Authority of New York and New Jersey sold during the week of Feb. 4 was only 4.3%, the rate more than quadrupled, ultimately soaring to 20% on Feb. 12.
A similar dilemma confronted the state of Wisconsin at its 28-day auction of taxable bonds on Feb. 12. Bonds that the state sold at 4.75% on Feb. 7 jumped to 10% five days later. Shortly after Ambac Financial Group, the insurer of student loan debt issued by Vermont's Student Assistance Corp., lost its AAA credit rating, the interest rate was reset from 5% to 18%.
Other bond auctions have failed outright, including bonds issued by Presbyterian Healthcare in Albuquerque, Georgetown University, Nevada Power and New York State's Metropolitan Transportation Authority and Dormitory Authority. According to New York Times reporters Julie Creswell and Vikas Bajaj, nearly 1,000 auctions failed during the three-day period between Feb. 12 and Feb. 14.
Bond-auction failures can have a devastating effect on the issuers, whose only alternative is to pay the higher interest rates or cut back on their programs. For not-for-profit entities, which depend on these instruments to raise funds for their institutions and programs, and municipalities that are forced to raise taxes to meet higher costs of borrowing, the consequences are even more severe.
In the wake of reduced tax revenues from a weakened housing market and a potential recession on the horizon, many state and local governments are increasingly worried about how they will pay their bills while still offering essential services. Michael Quint reported in Bloomberg.com on Feb. 15 that the Municipal Securities Rulemaking Board, which is the top regulator for the U.S. bond market, “is so concerned by the chaos in the auction-rate bond market that it plans to seek comment on whether dealers in these securities should reveal the number of bidders, and disclose how often these auctions fail.”
Reportedly, the Securities and Exchange Commission (SEC), which reached a $13 million settlement in 2006 with 15 investment banks involved in bidding irregularities, also is considering whether to require increased disclosure regarding the auction process.
Investors in these securities are no doubt feeling the sting. Individual and institutional investors that purchased the bonds — believing they were safe, low-risk securities equivalent to cash — now find themselves holding an investment for which there is essentially no market.
As a result, legal action already is brewing by several investors against the brokers responsible for selling the securities. Case in point: Merrill Lynch is a defendant in a Texas dispute in which Metro PCS alleges the firm misrepresented the risks involved and the suitability of the securities under the company's guidelines. Another case is Lehman Brothers, which is the respondent in a FINRA arbitration complaint filed by two wealthy New Jersey brothers who allege that the firm's investment of $286 million in auction-rate securities was inconsistent with the claimants' stated investment objectives.
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