Tuesday, February 12, 2008

Auction Rate Munis: Clumsy as they are stupid

The auction rate market is getting worse as the media is giving it more and more play. Today I heard Citigroup had at least two issues within my home state of Maryland where the auction rate was 10%. Three interesting notes on these two particular issues...

  • Both are insured, but one was FSA and the other was CIFG.
  • In both cases the underlying issuer has an "A" rating. One is a hospital system and the other is a water and sewer utility.
  • The auctions didn't fail, the 10% level was the rate garnered at auction.

I reiterate what I said the other day. There aren't any particular problems with municipal credit quality. Part of the problem is that ARS holders assumed that the auction facility assured they could get out. But there was never any such assurance. Now people are hearing that they own something that might have zero liquidity, literally, and they are panicking.

An interesting wrinkle to this story. There are lots of people who would be willing to take a chance on the credits which are involved in failed auctions. Problem is that the upside isn't that great. I mean, let's say you are looking the A-rated hospital. Sure the 10% auction coupon looks great. But that 10% may only be there for the next 28 days. It isn't like you can buy the bonds at a steep discount on the hopes that the problem resolves itself in a few months. In fact, if the problem resolves itself, then the auction will reset much lower, making the bond less attractive.

To see what I mean, contrast what's going on with ARS vs. long-term fixed-rate munis. We know fixed-rate munis are trading weaker than they would be without the insurance problems. But nothing is trading at 10%. In other words, the two issues Citi currently has would probably yield somewhere in the 4.25-4.75% range if they were fixed-rate issues.

I want to say more on the Buffett proposal, which I'll do when I have more time. I'm surprised the stock market reacted as favorably as it did, but I disagree with those who have been saying "it only helps munis so who cares." The fact is that Citigroup has pledged capital to holding these two ARS I mentioned, and probably dozens more. Its an area of contagion that just doesn't have to be. There's absolutely nothing wrong with these ARS.

So if someone comes in and basically makes the whole muni insurance problem go away, then that's one element of the contagion that's contained. I mean, we know the subprime problem is with us, and will be with us for a while. The market can price that problem. We can price declining home values. We can price damn near anything, but we can't price unknown and ever widening contagion. So in order to get to a bottom in risky assets, we need to get to a place where the contagion stops widening.

Of course, the old saying holds: no one is going to ring a bell when this has happened. But I think getting a solution to the municipal problem is a step in the right direction.

25 comments:

Jim L said...

I think your analysis of Buffett's offer is incomplete. I agree that the offer would benefit the muni market (if it were accepted, which I doubt it will be). As you point out, carving out munis from the financial contagion is helpful. Your analysis seems to end here.

However, I think you're missing the follow-on effects. Any monoline accepting Buffett's offer would be left with the riskiest part of their insurance portfolio - reinsuring the healthy part of the portfolio might reduce pressure on their capital, but wouldn't affect losses on the remainder of the portfolio. This would leave the insurer in a hopeless position, as evidenced by the decline in MBIA and Ambac's stock prices following press reports about Buffett's offer.

The offer would salvage the muni market at the cost of further scorching the various forms of mortgage-backed securities covered by the monolines, and worse yet potentially triggering a cascade of defaults on credit-default swaps. It's not obvious to me that this is a net positive.

I'm curious to hear what you think about this.

Regards,

Jim

Josh said...

Hi, I love your blog.

I work at an investment bank and we are limited to trading either via E*Trade or via the private client group, which I've never done before.

But, I'm thinking to buy into some of these ARS's for as long as they yield well. Any idea how an end-user does this?

Thanks, Josh

gramps said...

For the past few years, lots of hedge funds have been doing the S&L thing with muni bonds -- borrow short and lend long.

Municipalities want to issue 30yr (or longer) debt, since this makes the annual payment the smallest (usually). Of course, many (most?) muni investors do not want to lock up cash for 30yrs.

Enter hedge funds. Buy the 30yr bonds inside a trust (aka SIV), and have that trust pay out tax free interest maturing in 364 days or less. The supply of muni money market paper expands, the demand for 30yr muni bonds expands-- and the hedge funds collect the spread. In essence, its a total return swap, 30yr muni rates for 1yr floating muni rates-- although it doesn't cover the full quantity of the 30yr bonds (so additional liquidity is needed from outside the trust).

Like everywhere else, the SIV in these cases isn't truely balance sheet remote. When lenders start seeing all these "borrow short, lend long" vehicles blowing up -- they get nervous and refuse to roll over financing. Hedge funds try to unwind the trades -- and turns out there aren't enough "legitimate" 30yr buyers out there. And Wall Street's balance sheets are hardly in a position to absorb much. The HF is left holding the debt on its balance sheet.

So the funds stop buying new bonds at almost the same time municipalities ramp up borrowing in the face of falling property taxes and unlimited spending (well, at least in the case of the Gubernator in CA).

Lots of new supply, while demand is drying up.

Next thing you know, many (not all) tax free muni bonds are yielding higher than taxable Treasury bonds.

Historically, muni bonds "almost" never defaulted. But a few have and many have come very close. Rich people didn't get that way by lending money to spendthrifts who can't pay it back -- and if Americans are honest with ourselves... we are not a very good credit risk. We spend **WAY** more than we make, and we are constantly demanding the government increase benefits while decreasing taxes. When taxes are increased by $1, we immediately want the government to spend $2...

Ever try to understand your town/city's cashflows? Government accounting standards make Enron look like the boy scouts. The first off balance sheet financing was done by New York State to circumvent debt limits (NY created the NY Turnpike Authority and had *IT* issue debt in lieu of the state).

Corporations are required to accrue money for pensions and healthcare benefits -- many states do not accrue funds for either, and most states do not and did not accrue money for healthcare benefits -- but you can bet the municipal unions will demand the benefits be paid. Last year, Texas passed a law to allow the state treasurer to ignore GASB accounting rules that would have required the state to set aside funds to pay for benefits. If you think GM has unfunded pension / benefit liabilties, keep in mind that you at least know the extent of their problem. Your state is likely in a similar boat, but the accounting rules don't allow you to find out how much.

Former Goldman CEO Jon Corzine (now Gov of NJ) has tried to understand some of the swap arrangements that municipalities have entered into -- and he is reported to have said he could not understand a lot of them. If a former Goldman CEO doesn't get it, I am willing to bet the local bureaucrats understand it even less. And only a limited group of investors are going to have the expertise.

So what are you buying when you buy a modern muni bond? Its clearly not your grandfather's muni bond, so historical default rates are not helpful in predicting future defaults. The unfortunate reality is... the muni Treasurer doesn't really understand what he is selling, and investors have absolutely no idea what they are buying.

Many (majority?) bonds are perfectly good. Many others are trash, and will end up with problems and/or default. But the muni market is the antithesis of transparent, so you really have a hard time knowing which is which.

In hindsight, Buffet seems to have bought GenRe thinking it was a reinsurance company, and not realizing how much derivatives exposure he had. And he had a tough time getting his hands around it after he became the owner. Also in hindsight, the derivatives exposure was small relative to BRK and he was able to unwind many of the transactions.

I agree he is cherry picking assets from AMBAC et al. I am not sure he knows what exposure he is getting himself into (if only because the figure is unknowable). I don't really understand the full nature of Buffet's deal, but assuming he is offering **reinsurance**, AMBAC et al would still be the primary insurers, and Buffet's total liability would be capped by the policy (reinsurance policies do not offer unlimited coverage).

BTW, some of the biggest **REAL** (not leveraged) buyers of muni bonds are insurance companies. So restoring order to the muni market would benefit big insurers, like say Berkshire Hathaway. Buffet benefits there too.

Bullwinkle said...

Is part of the problem with auction rates due to the precipitous drop in Libor? If these bonds are long term and no longer insured, the rates should reflect long term uninsured bond yields, not some tight spread off of Libor. This is just a wild guess as I'm not involved in this market.

Accrued Interest said...

Jim: I think its obvious that the monolines won't take Buffett's deal voluntarily. They might be forced to take it by regulators.

If the insurers are split between munis and other, then clearly the value of the insurance will plummet. But right now the insurance isn't given much value anyway. So I think what you get is one market (munis) where the problem is solved and another market (SF) where people were assuming no insurance anyway.

Like I've been saying, there are no "solutions" where the problems of bad loans and bad securitizations just go away. So I'm loathe to attack any plan just because it doesn't "solve" all our problems.

John:

ARS are sold primarily by larger broker/dealers. I'd say your private client group is your best bet.

Gramps:

You are refering to TOB programs, which I wrote about before. The big problem with TOB's right now is many have become forced sellers. They've made long-term muni yields rise well above Treasury rates in many cases.

I will concede that property tax collections will be strained, but consider the calculation method. Most states only estimate home values every 3 years. So 1/3 of homes are going to be revalued this year from 2005. In other words, budgets won't suddenly get slammed.

Bull:

I don't think the problem is LIBOR, because like I said, long-term munis of similar types are yielding in the 4.5% area. Not 10%.

Anonymous said...

I just discovered your blog and I really enoy it....I will be a regular visitor for sure. Unless I am missing something, the biggest risk here is that you may get stuck holding these securities for a while. What I was curious about is what causes these auctions to fail? Is it the market as a whole or the lack of interest in the specific bond?

Also, is it realistic to think you could get "stuck" holding the bond to maturity?

Thank you very much for any insight.

Jim

Accrued Interest said...

Auctions fail because there are more sellers than buyers. Its that simple. In the past, it was common for the dealer to step up and buy ARS when auctions looked like they might fail. Now that ain't happening.

It doesn't appear to matter who the issuer is. Today it came out that the Port Authority of NY/NJ had an auction fail, and the bonds have reset at 20%. There is nothing going on with the Port Authority to suggest they are in trouble right now. I think the panic is overwhelmingly just fear that owners will be stuck with bonds.

As far as being stuck until maturity. I guess its a never say never situation. Realistically what's going to happen is that either the rates will normalize in the next 2 months or the issuer will refinance the debt.

Anonymous said...

Last question. So if you are an investor in these and it is a very good bond as far as ratings go, it seems like if these auctions fail it is actually good for the holder if they don't mind sitting with them for a few months or so?

Thanks again,
Jim

HunterW said...

Good post, very informative. The general feeling is that munis are good credits, and I have no disagreement with that in regards to those borrowers with taxing authority. However, I am told that a significant amount of munis are backed only by the credit of a private company or specific project. These credits are only as good as the company/project behind them.

Is this true? If so, does anyone have any insight as to how much of the ARS/VRDO issues are in this category?

Accrued Interest said...

Jim:

Yes. If you don't care about the liquidity, then you may as well get paid more, right?

Hunter:

This is just a guess, but I'd wager that few ARS are general obligation bonds. I think there are four layers of muni credits. You have straight government bonds. Then you have essential government agencies. That would be something like your sewer system. Then you have non-essential goevrnment agencies. Still part of the government but in a real disaster, there's no guarantee the government bails you out. That would be something like a state student loan program. Then at the bottom are true projects/operating entities, like a hospital.

In my experience, ARS are tilted toward the bottom of that scale. I don't really know why, but it seems issuers like the State of New York or some such rarely issue ARS. But you do have a fair amount of all three of the other categories. So if you are someone who really wants a pristine credit in ARS, it isn't hard to find.

Richie said...

Anyone have any thoughts on how this is going to affect Closed End Municipal Bond Preferred Auctions. I heard that some of their auctions came up dry yesterday as well. I see this as a VERY bad development since most are somewhere around 30-35% levered and a combination of higher borrowing costs and the long term securities they hold (which have undoubtedly lost value) is going to absolutely KILL their NAV.

Accrued Interest said...

That's certainly a danger. If you own any CEF, you should look into how they are structured and how the leverage works.

Anonymous said...

A good way to play this phenomennon is through PVI. It is a Powershares ETF that owns a mix on municipal ARS. It currently pays 3.5% but will surely go up. Thanks for the great posts

Dave M. said...

Closed-end funds like JPS and HPI got hit hard today. They are leveraged funds that hold investment-grade preferred stocks. Most likely the reason was the auction for leverage financing failed?

Accrued Interest said...

OK Bloomberg users can type in the ticker for a closed-end fund, then type RELS. #19 is Preferreds. Pull up the DES on any of the prefs. #2 is "Floating Rates" which gives you a history of the Auction results.

Looking at JPS, none of the prefs look like they've have a failure. All of them are in the 3-4% area.

Eric said...

"Realistically what's going to happen is that either the rates will normalize in the next 2 months or the issuer will refinance the debt."

Is there a danger that issuers will be unable to refinance their debt (at least at below nosebleed rates), especially if lots of them are trying to do it all at once?

Anonymous said...

I work in an Inv Bk and know a thing or two about this product. The high rates you are hearing about at the penalty rate that the issuer is forced to pay holders in the event of a failed auction. They are obligated to pay that rate until there is a subsequent successful auction, the auction is converted to a VRDN structure or is otherwise called (refied) by the issuer.

As AI and others have pointed out, in the vast majority of these issues, the credit is no less attractive today than it was two weeks ago before this mess started. Thus, a municipality paying 1mL+200 or a double digit fixed penalty rate has all the incentive in the world to either extend the auction (6, 12 months) which could clear it, convert to a VRDN structure or otherwise refinance and call the failed deal. If the issuer's normal Libor spread is, say, 75 bps (pretty steep), they can go out right now and issue 12month paper at a 3.50% taxable. Compare that to either the Libor formula or high fixed penalty rate. It would appear to be a no-brainer.

The biggest impediment to the market finding a solution is that there are only so many investment banker and lawyers in this space and there are literally thousands of cusips involved. It will take 3-6 months or more.

Also, there are a number of savy institutions who are coming in and buying the 10%+ paper right now. Their view is they don't need the liquidity and will hold the failed paper for as long as it takes to clear up.

Slowly, this process will clear the log jam.

One last thought, many of the IBs closed their fiscal quarters on Feb 29th. Could it be that they did not want to overinflate their balance sheets ahead of the qtr's close? Will that free up some balance sheet liquidity come March 3rd? Hmmmmm...

Anonymous said...

To Richie: the penalty rates vary from one closed-end fund's auction preferred to the next, but Eaton Vance just came out with a very helpful summary of the penalty rate on all of their auction preferreds:

http://www.eatonvance.com/closed_end/APS%20Update%202-14-08.pdf

The bottom line is that the funding rate even in the event of an auction failure is below the yields on the securities they own with the leverage, which is a positive of course. I haven't seen a similar statement from Nuveen or other closed-end managers yet.

Anonymous said...

I found your recent article on the muni market very helpful and informative. I’m trying to determine how an liquid individual bond investor might profit from the market turmoil. You wrote that “Sure the 10% auction coupon looks great. But that 10% may only be there for the next 28 days. It isn't like you can buy the bonds at a steep discount on the hopes that the problem resolves itself in a few months. In fact, if the problem resolves itself, then the auction will reset much lower, making the bond less attractive.” Which I understand and agree with, but if im currently averaging 5% on my bond portfolio, all of it can be liquidated today, I don’t need the money for the next 10 years and it takes the market 6 months to resolve the credit issues, what is the downside to purchasing these instruments? Also, can you tell me how these are priced, if a current port authority bond holder is now being paid 20%, can the bondholder sell the bond above face value? How are these bought, sold and who can fill orders?

Accrued Interest said...

Anon:

There is absolutely no downside to owning ARS as long as you understand the liquidity may be zero. Otherwise, have fun. In order to buy ARS, you have to have a relationship with the remarketing agent, which is usually one of the larger broker/dealer firms.

Its increasingly obvious that closed-end funds are the way to play this thing. I just doubled up my exposure to closed-end muni funds. Almost all the funds I'm finding have similar ARS penalty rates as EV's press release. It looks like nothing is going to reset above 4% for the time being. Which means the CEF are all in fine shape.

Meanwhile, almost all of them droped 2-5% yesterday, with several falling again today.

Anonymous said...

Thanks for responding to my question, can you tell us what funds your doubling up on? thanks

Accrued Interest said...

Uhhh... these things are pretty thin so I don't want to be seen as pumping my own positions. Put it this way: I've looked at some of the biggest 2 day drops, checked all the ARS related to that fund to double check there were no weird resets, and then I bought it. I didn't find ANY with resets higher than 3.3%.

Anonymous said...

That is understandable, i would like so see what you came up with and then do research on my own to determine if these types of positions are suitable for my account, my email is triple.rruns@gmail.com, if your comfortable sending the positions, i would appreciate it. I will keep them confidential. thanks

Accrued Interest said...

See my next post.

Shawna said...

Well, I don't really think it will work.