Friday, February 22, 2008

It's too late to protect your ARS

(Mish's Global Economic Trend Analysis) Auction Rate Securities (ARS) auctions continue to fail. Todd Harrison on Minyanville noted that 186 out of 268 auctions failed yesterday. That's a failure rate of 69%. The failure rate was 73% Tuesday and 80% last Friday. Let's recap the ARS action starting with an explanation of what an ARS is.

What is an Auction Rate Security?

An Auction Rate Security (ARS) typically refers to a debt instrument such as corporate or municipal bonds that have a long-term nominal maturity, but are refinanced as often as every week via a dutch auction. Auctions are typically held every 7, 28, or 35 days and interest on these securities is paid at the end of each auction period.

The theory behind these auctions is that long term debts can be perpetually financed at short term rates. That theory has now blown sky high.
I discussed Auction Rate Securities on February 14 in No Underwriter Support For Failed Muni Auctions and Turmoil In Munis: Yields Soar To 20% on February 13. Let's take a look at more recent events.

Auctions yield chaos for bonds

The Herald Tribune is reporting Auctions yield chaos for bonds.
As municipal bond auctions continue to fail — and to produce very odd interest rates when they succeed — it is becoming clear that the auction-rate market is in crisis and chaos, and many securities may never have a successful auction again.

If they continue, the auction failures could lead to the selling of billions of dollars in municipal bonds. That, in turn, could push up the rates that cities and states must pay to borrow money.

The failures also indicate that talk of rescuing municipal bond insurance companies, like Ambac and MBIA, has not reassured investors. Auctions continue to fail, even at absurdly high yields, if the principal guarantee of repayment is an insurance policy.

The auction-rate market was invented in 1984 by an investment banker at Lehman Brothers, Ronald Gallatin. The idea was to issue long-term securities that could pay their buyers interest rates only a little above short-term rates. That was accomplished by having periodic auctions to reset the rate. As long as the auction succeeded, meaning there were willing bidders for the securities, any holder could sell the security at face value whenever there was an auction.

If an auction failed, the interest rate would rise to a penalty level that no company — or municipality — with decent credit would agree to pay for long. That issuer would then redeem the bonds.

So long as the auctions worked, the only risk to buyers was that an issuer's credit would go bad and the buyer would be stuck with the bonds.

The first auctions were for auction-rate preferred stock, but the idea soon spread to municipal bonds and then to preferred shares issued by closed-end municipal bond funds.

It is those last securities that seem least likely to resume trading anytime soon, largely because the penalty rates attached to them are so low that they will not attract new buyers. In a classic Catch-22, a low failure rate makes failures more likely.

"That should cause the leveraged municipal bond funds to redeem their preferreds," Gallatin, now retired, said Tuesday. He noted that at those penalty rates there was little benefit to common shareholders, and that preferred shareholders were suffering because the liquidity they expected was no longer there.

The fund companies no doubt will resist such redemptions, in part because it would cost them some management fees. But fund directors have fiduciary responsibilities to all holders, which could force them to consider redeeming the preferred securities. If they do, a quarter or more of bonds held in such funds would have to be sold.
Total Insecurity In Auction Rate Securities

On February 18 Financial Week was reporting Auction-rate securities suffer total insecurity.
Every major broker-dealer has seen its auctions fail as of last week. These things are dead.

Auction-rate securities continued to crater last week, after banks failed en masse to back auctions and news of lawsuits further rocked the market. That’s left many more companies stuck with illiquid securities—an estimated one-third of U.S. corporations invest in auction-rate securities—with only a hope that the underlying bonds will be called, as more industry watchers forecast the death of the auction-rate market.
Spillover Into Auction Rate Preferred Shares ARPS

On February 19 Blackrock offered a Closed-End Fund Market Update.

The credit market issues of recent months are spilling over into other corners of the credit markets, including the market for auction rate preferred shares (ARPS), which now appear to be experiencing a lack of buyers. ARPS are one of the primary instruments used by many closed-end funds, including BlackRock's closed-end funds, to leverage municipal and taxable fixed income portfolios.

Closed-end funds issue ARPS with the goal of paying higher dividends on the fund's common shares. The fund, in essence, borrows money at short-term rates by issuing ARPS and invests the proceeds in longer-dated securities. This allows the fund to capture the "spread," if any, between short- and long-term rates and pass it along to owners of common shares as incremental dividends.

Closed-end funds historically have had an extremely high rate of successful auctions for these ARPS. However, recently there have been numerous failed auctions across funds by various fund sponsors, including BlackRock.

Professor Sedacca is asking ....
What happens when you dial 1-800-get-me-out and no one answers?

I continue to get calls regarding the Auction Rate Securities market. As I mentioned yesterday, the market has become bifurcated in a short time. Word has it that large institutions (including hedge funds and others) are bidding a few basis points south of the 'maximum rate' to get the deal done, but at an advantageous rate. Eventually, I imagine the issuers that can issue long dated paper will either do a fixed rate deal or go to a line of credit at a bank syndicate.

The ARS's on closed end funds are a completely different animal however, and dominated by retail. Most of these deals have a max rate that is 110% of a commercial paper index. This amounts to 3-4%. Ladies and gentlemen, this is truly the roach motel. I see no way on Earth that a hedgie or insurance company will come to the aid of the retail investor and gobble these securities up at 3.5%.

1-800-get-me-out is lit up, but no one answers.

I truly feel badly for those stuck in these securities and am not criticizing anyone for owning them. I am just saying that if you own these, read the prospectus and understand the terms. They are available on Bloomberg so your broker should be able to get it for you.

I just wouldn't count on getting out any time soon unfortunately.
Pain in the ARS

The classiest title in the Muni, ARS and ARPS realm goes to to professor Sedacca who is writing It's a Pain in the ARS.
Bifurcation Develops in ARS

There are two distinct parts of the Auction Rate Securities market. On one hand, you have individual issuers like municipalities, hospitals and school systems. Generally speaking, the individual issuers have ‘maximum rates’ for their issues, typically in the 10-15% range.

We really haven’t seen too many ‘failed auctions’ in this arena, simply a lack of short-term liquidity that forces the rates up for the issuers. To be sure, there is a bit of short-term pain that develops for the issuers, but to the extent that the underlying credit ratings are sound, buyers for this paper are slowing surfacing.

I have heard many stories that hedge funds and large institutions are buyers of this paper as it is clearly mispriced. The end game is that the rates will likely settle into a more realistic range over the intermediate term, and that these institutions will roll their ARS into fixed rate bonds or possibly into letters of credit, if they have the facility available to them.

Imagine that you are an opportunistic hedge fund and that you knew that the ‘maximum rate’ for an issuer was 15%. Wouldn’t you step into the auction and bid 14.95%? It's a rhetorical question, isn't it? Of course you would. The issuer would surely be irritated and quickly wish to refinance into a fixed rate deal, but setting up these deals takes six to eight weeks. And there will be loads of issuance. So there will be quite a rush to the market to rid you of this potential outcome again in the future. This is why I expect a flood of fixed rate issuance, led by the highest quality issuers. Once that market develops, others will be able to offer new issues.

But what about the ARS that help finance the levered closed end municipal bond funds? In my last piece, I wrote that the funds were nothing more than a "margin account in drag" and indeed they are. The basic structure of these funds is one to benefit issuers, brokers and investment banks.

Imagine that you go to the market and buy $100 million of municipals and then borrow $50 million at a lower rate that raises the yield of the fund, except for the fact that the average fund charges over 1% per year in management fees, which drags the yield back down to what you could earn if you just bought the bonds for yourself.

I'm not trying to beat up anyone here and am just pointing out how "Mom and Pop Retail" get stuck holding the bag. So here comes the real shoe to drop. What happens to you if you are the holder of an auction rate security of a closed end fund? As I stated previously, the "maximum rate" on many of the individual issuers is 10-15%. I suppose those rates were set arbitrarily as no one ever imagined the market could seize up like this. But I truly believe that will be a temporary phenomenon. The case for closed end ARS is much worse, perhaps catastrophic. Most closed end funds have a stated maximum rate of 110% of the 60 day commercial paper index. And let’s say that index is at 3% which results in a maximum rate of a whopping 3.3%. Not so great, right? Now here comes the bad part.

Let’s say that the Fed keeps cutting rates as we expect as the economy worsens. And let’s say that 60 day commercial paper drops to 2% and the maximum rate falls to 2.2%. This is not a great proposition for the holder. You are now left holding a long term piece of paper that you can’t get rid of (who would want to buy your bonds on a 2.2% yield?). One of the issues with ARS in closed end funds is that they have "workout dates" that are quite far into the future, as much as 40 to 50 years.

Going one step further, the bond now becomes a 40 year 2.2% world—in a world where 40 year municipal bonds trade at say, 5%, due to the aforementioned heavy amount of issuance. What would that security be worth? I can tell you that our firm has toyed with the idea of buying ARS of solid municipal credits north of 10% but if anything, I would consider selling short these ARS of closed end funds at par. The reason is that a 2.2% bond with a 2049 maturity and a 5% yield trades at 51.387 cents on the dollar. And a 2.2% bond that trades on a 6% yield (I could imagine that this sort of issue would trade at a discount to high quality individual issuers) would trade at 42.271 cents on the dollar.

The only thing I can say is, if you can get out of these ARS with minimal pain, get out while you can. I imagine a market will develop over time for them, but most people bought these securities as ‘cash equivalents’ to pay income taxes and such. Instead, Wall Street once again created the worst of all securities that I like to call the "Roach Motel"—where you can get in but can never get out. ....

One last thought and this one may really be the biggest issue of all. Most municipal bonds are "marked to matrix." In other words, most AAA insured bonds are all lumped together and priced similarly. But therein lies the problem! ...

If I owned a bunch of municipal bonds, I would want to know what the underlying rating was on every bond I owned, whether it was pre-refunded and whether or not it was on a credit downgrade list. The other problem is the NAV (net asset value) of both open end and closed end municipal bond funds. I have a sneaking suspicion that the NAVs are grossly overstated and that a re-pricing will develop, only to be made worse by the large amount of issuance I foresee. So as this shoe drops, it may drop hard on a lot of people.

Consider the following exercise: Take a look at your brokerage statement online if you own a bunch of insured munis. Then ask for a bid. You may be surprised at the answer.
If you are in a closed end muni fund or are sitting on munis of questionable value "guaranteed" by Ambac or MBIA, you may wish to get while the gettin' is good (if it still is). For many, it is likely to be too late to protect your ARS.

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