Tuesday, February 05, 2008

You have failed me for the last time, Auction Rate Municipals!

I've received several e-mails in the last couple days about municipal auction rate securities, after auction failures in both Nevada and Georgetown University. The e-mails ask three important questions.

1) What the hell is an auction rate security?
2) Why the hell are the auctions failing?
3) How much should we panic?

Well fortunately, its all pretty simple. When municipal issuers want to sell variable-rate debt, they normally do it one of two ways. One is called a Variable Rate Demand Note (VRDN), and the other is called an Auction Rate Security (ARS). Both work pretty similarly. I'll describe the auction bonds in detail because those are making news.

Auction rate securities usually have long-term maturities, 30-years or more. The rate is determined by auction, which is conducted by a broker/dealer firm, often called the "remarketing agent." The auctions occur at regular intervals, commonly every 28 days. Potential buyers give the dealer a rate at which they would buy some amount of the bonds. Current owners of the bonds can also put in a rate in which they'd sell, although typically those that want to sell just tell the dealer to sell at any rate. The seller gets par no matter where the rate is set. The rate is set at the lowest rate which clears the market.

ARS are sold to investors who want to take very little risk. While the auction process and the ability to sell bonds at par within a few weeks assures that interest rate risk is low, other means are needed to mitigate credit risk.

Most commonly, a bank is brought in to provide liquidity support. In general, the bank provides full credit support, assuming the issuer hasn't already defaulted. As a result of this, investors in ARS don't have to worry that the issuer will have enough cash on hand to handle sales of their bonds. As long as the issuer is current on its interest payments, the bank will provide cash for normal redemptions of bonds. Think of it like a line of credit.

Here is where things get a little weird. Sometimes the issuer of a ARS was a little more sketchy credit. The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We'll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven't seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank's liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

For most ARS buyers, that's not acceptable. ARS buyers tend to be money-market like investors, who have zero desire to take on credit risk. So what are those bond holders doing? They are selling the bond back to the remarketing agent! See, while the insurers still have a AAA or even AA rating, the liquidity facility is probably still in force. So ARS owners know they can get out now. They don't know they'll be able to get out at the next auction, 28 days later.

Notice this problem would only apply to ARS with dual credit support. ARS with just a straight liquidity facility wouldn't have a provision relating to insurer downgrades, so there are no problems. So what might have seemed like an extra layer of support turns out to be a loaded gun pointed at your head. The phrase "That's no moon" comes to mind.

So clearly we have more sellers than buyers. Of course, such a situation can happen on any given auction period, where it just happens to be that more sellers show up than buyers by happenstance. In this situation, the remarketer would normally take the extra bonds onto its own books, figuring they can sell them to investors in the coming days.

But this is not a typical situation. Dealers are unusually capital constrained, making them less willing to take bonds onto their books. And the uncertainty of credit support makes it very difficult to sell the bonds, even at elevated interest rates.

The result? A failed auction. That simply means there weren't enough buyers to accommodate sellers, and therefore not all bonds offered for sale were sold. In such a case, the bond documents dictate some maximum interest rate at which the bonds reset. In the case of the Nevada Power deal which failed, the rate was 6.75%. Consider that is a tax-exempt rate, and would be something like 350bps over LIBOR. Non-problem ARS are currently yielding less than 3%.

Remember if you are a holder of this problem ARS paper, you may be stuck with your bonds for a little while, but you are getting paid a handsome yield on a bond where the ultimate credit (the issuer) isn't a problem. At least not right now.

Obviously for a bond issuer who is not having operational problems, having to pay an extra 3-4% on your bonds doesn't sit too well. So what can be done? Well, typically ARS are callable on any auction date, which means that issuers of this paper are going to refinance their debt (without Ambac insurance thank you very much) en masse in the coming months.

The big "so what" on all this? Well, it turns out to not be a very big deal. Issuers will wind up having to pay a fee to their investment banker to refinance the debt, but that's manageable. Some issuers may use this occasion to call their variable rate debt and sell fixed rate debt instead, given that interest rates are low. Assuming the debt is indeed refinanced, the ARS holders who are currently "stuck" will get taken out when the bonds are called.

You can decide for yourself how much you want to panic.

38 comments:

Anonymous said...

Very informative post, thanks.

Here's a story about what happened to the NY MTA's issuance after Fitch downgraded SCA from AAA to A: NY MTA mulls how to handle XLCA-backed debt

Do you know what proportion of the $1.35 trillion in muni bonds insured by the monolines have these ratings-dependent liquidity support agreements?

Anonymous said...

Great 'Star Wars' reference.

Anonymous said...

I agree with most of your post, however, towards the end I believe you downplay the risk that auction rate securities represent in today's market. Notice that Bristol-Myers wrote down $392 million of the $811 million they owned in auction rate notes. Of the $392 million, $275 million was "other than temporary" or permanently impaired. Bristol-Myers is not the only company suffering here, check out US Airways, 3M, Qwest and Synaptics for a few others who have taken write-offs associated to auction rate notes.

Most of the auction rate notes that I am familiar with do not require the broker/dealer to buy back the bonds. Once upon a time when markets were more liquid and the banks had more capital, they were willing to step in as a bidder of last resort to make sure auctions did not fail. However, given the changed dynamics in the market they have stopped providing this type of support.

The one other comment I would like to add to your post is that there is a lot of variation in the underlying collateral of auction rate notes. For instance and not surprisingly, auction rate notes tied to the monoline insurance industry have been failing since last August. These types of auction rate notes provide contingent capital for the monolines.

The basic structure is as follows. A trust is established that holds very short-term commercial paper of high quality. Investors in the notes actually hold a portion of the trust. The sponsoring monoline insurer has a put agreement with the trust that allows the insurer to put preferred shares of the monoline to the trust in return for the commercial paper at their discretion. The benefit to the monoline insurer is that this "capital" is considered part of their capital structure when the rating agencies review them, but it does not show up on their balance sheet giving them a better return on capital than otherwise possible.

Given the uncertainty around the viability of many of the monoline companies it is easy to understand why the market for the associated auction rate notes as dried up. I cannot imagine a conservative investor being excited about owning preferred shares in a monoline at this point in time.

the cds trader said...

i don't think it all makes sense.

if no-one wants bonds for less than L+350, how is the issuer going to refinance for less than this? sounds to me like they aren't, so the holders are stuck and just going to have to mark the bonds down.

if any holders of this stuff are only just panicking now, i'm amazed. if i'd owned any, i'd have panicked out of them by last august AT THE VERY LATEST. anyone still holding deserves to lose everything.

Accrued Interest said...

Anon #1: I don't know what proportion, but its a minority. Most ARS/VRDN's don't have insurance, just LOC's.

Anon #3: You are talking about structured finance ARS, which is a completely different story. The auction rate structure was used by some mortgage, student loan, and CDO structures. Not the majority, but some. These types of bonds would have the same problems as other stuctured finance vehicles in this market.

Accrued Interest said...

CDS: They can refinance because they will restructure the liquidity support. See, bonds that still have solid liquidity support are reseting at "normal" levels.
So all the issuer has to do is eliminate the secondary insurance, and everything is golden. It might be that the bank providing liquidity asks for a larger fee, but given the circumstances, the larger fee will be worth it.

As for why people are only just now dumping these bonds? I'd say that for a while, dealers were buying for their own books, which prevented an auction failure.

Accrued Interest said...

I will also say that the provision involving insurer downgrades was probably not well known. I do own some ARS and some VRDN's at our firm, by coincidence none of these had secondary insurance. But if you pull up a CUSIP on Bloomberg of one of these dual-support bonds, it looks like you are backed by both the insurer and the bank liquidity provider. There's no reason to assume that the bank support could disappear if the insurer is downgraded.

So I'm betting that a lot of people assumed that even if their monoline insurance was downgraded, they'd still have strong support from the bank liquidity provider. Turns out that's wrong.

anonymous 4 said...

Nice post but a few clarifications regarding the Municipal ARS and VRDNS.

ARS are auctioned every 7/28/35 days much like a new issue may be auctioned. Generally the source of liquidity to the existing investor is the auction. Possibily they could find a new buyer without the auction. The sponsor bank is only an auction agent, collecting bids and presenting them to some trustee bank which determines the auction clearing rate according to established rules (generally dutch-auction), or if there is a fail the existing holders keep the ARS at a higher coupon for the next 7/28/35 days until the next auction. If no new buyer ever emerges, the original investor may end up holding the bond to maturity (30y or more). The investment bank does NOT have to take back or bid for the ARS at any price, nor does anyone else. There is no liquidity agreement on an ARS. Hence, ARS are not an eligible investment for money market funds. The market may believe the sponsor bank will implicitedly support the auction, but investors should not believe this. The sponsor bank may include their own bid in the auction if they wish to, though they do not have to.

A VRDN on the other hand, does not re-auction every 7/28/35 days. Instead, the sponsor bank re-markets the bonds every 7 days generally. The sponsor bank, acting as remarketing agent, collects bids from investors and determines a clearing rate in their best estimatation including using their own capital if they deem it necessary. There is a liquidity bank which provides a back-stop bid for the bonds, guaranteeing investors a source of liquidity (note liquidity agreement take several forms, some of which give rather limited "liquidity"). Because of the explicit liquidity agreement, these bonds are generally money-market eligible.

Also, in the municipal market I would say the majority of ARS have insurance. I will ask around, but uninsured ARS were a development which started in 2003ish. Because of the lack of liquidity support (or implicit sponsor bank support) bankers generally required insurance until issuers started pushing back. The Student Loan ARS market, a very big segment or ARS, did not always have insurance, but the true muni ARS generally did.

Anonymous said...

What I absolutely love is how incredibly rotten the entire system has become. Rats fleeing a sinking ship ain't in it.

Anonymous said...

-issue with ARS is not just the structure but also disclosure.
- they are marketed as super safe investment to investors by brokers without highlighting the liquidity risk, information on underlying collateral support, principal risk etc.
- I had a good amount in muni ARS (tax reasons), but I pulled out because good/uptodate information was hard to get and the risk for a lousy 2-3% gain was not worth it.

Accrued Interest said...

There are a lot of investors finding out that they owned securities they thought were very safe. But when the security was dependent on monoline insurers, then suddenly all those bonds get weaker at the same time.

wagner2626 said...

What exactly did the monolines insure in these notes?

Band Uncle said...

My understanding of most muni ARS is that there is no liquidity facility and the insurance only backs the payment of interest (weekly, monthly, etc) and the ultimate principal (20-30 yrs hence). Nearly all of these are insured and most seem to be non-essential issuers, e.g., hospitals, economic development authorities, etc. There seems to be a wide range of pricing, even among the insurers. I've seen Ambac ARS range from 2.8 to over 4.25. I agree with AI, these will eventually clear and the the default interest is pretty handsome, but if you expected and needed the cash you will be disappointed and selling below par.

Accrued Interest said...

I may have spoken too soon when I said the ARS are usually not dual insured, but I know for a fact that plenty of ARS have bank credit support.

Anyway, a similar problem is croping up in VRDN's, although there is no such thing as an auction failure in that structure. I heard Mellon Bank had a series of VRDN's for a PA student loan program which is resetting at 5.50% tax free!

Anonymous said...

How would one buy ARS or VRDN's? I do not have a money manager, manage my own small brokerage account.

:/ said...

Do you know what proportion of the $1.35 trillion in muni bonds insured by the monolines have these ratings-dependent liquidity support agreements?

About half of the muni market is 'insured'. Most ARS have only credit cover from a monlline, not bank liquidity cover. broker/dealers have been forced into 'involuntary asset growth' as ARS subscriptions are not renewed and the dealers have treid to stablilize the market below the max rates in the ARS documents. Late Friday, some new student loan ARS failed. This market is failing and faster now.

Accrued Interest said...

Your broker probably sells them. Just ask him/her about it.

Tyler said...

I attended a seminar on Friday, during which Moody's rep was discussing recent modifications made to the TOB legal agreements to reassure panicky investors. These agreements, which allow for the tender to be rescinded under certain circumstances, (downgrades and defaults being the most pertinent here) have been extended to cover both the issuer and the liquidity provider. That is to say, if Lehman backstops a State of Washington TOB program, both Lehman and the state of Washington would have to suffer downgrades to junk prior to the next tender, for the tender to be rendered inactive. I'm curious if anyone has seen similiar steps taken in the plain old ARM market?

Anonymous said...

There is one Auction Reset Security on Fidelity that just reset at 12%...not understanding why it reset at 12%...yikes!...could that be a failure? This is a NJ muni that is insured by Ambac and is reset every 7 days with a minimum lot size of 25K.

Here are the details:

Offering AHS NJ 2003-B
CUSIP 64579FHD8
Pay Frequency --
Coupon 12.000
Maturity Date 06/15/2018
Moody's Rating AAA
S&P Rating AAA
Material Events YES
Call Protection NO View Schedule
Sinking Fund Protection YES
Put Option NO
Bond Type MRESET
Interest Accrual Date 07/18/2006

Accrued Interest said...

I'd guess its a failure. You'd have to read the docs to find out.

Great example of a bond that is sure worth the risk at 12%! The hospital system has an "A" underlying rating, so even if AMBAC weren't in the picture, its still an A-rated bond.

Heard the Port Authority of NY/NJ has to pay a 20% this week! I'm telling you, pressure is going to really going to hit the insurance regulators to step in now.

Anonymous said...

This is very useful; thanks! Any idea how I would find out auction results for the auction-rate preferreds used to lever up a particular closed-end fund (EFT in this case)? I have access to Bloomberg but could not find the auction results, even with CUSIP in hand. I am concerned that if the auction of these preferreds begins to fail, then the fund may be borrowing at a penalty rate of who knows what in order to own senior loans yielding L+300 or so. The fund's manager/sponsor could not tell me.

Accrued Interest said...

Post the CUSIP here, or e-mail it to me. I'll check it out.

Anonymous said...

I manage over $1B of client money and i can tell you that most financial advisors are also in panic mode as this AAA-rated "safe" paper is all of a sudden surrounding by uncertainty.

AND - 90% of the market FAILED TODAY!!! That said, if you know what you're doing, it is absolutely an opportunity to pick up yield...just make sure you own the right underlying credit. For example, a Texas water and sewer - if you read the actual 2 inch thick document is backed by the full REVENUE (not profits) of the municipality -- OR what about a G.O. backed ARS --backed by the full taxing authority of the state -- I'll take this paper ALL day long over other alternatives - especially money-markets....why do you think Warren Buffet offered to reinsure the stuff (and they rejected his offer)...it's a "no-brainer"

Anonymous said...

Very inaccurate - I work at one of the major dealers and structured these securities directly for eight years - auction rate securities have never been issued with a line of credit - hence the risk that you are solely dependant on secondary market support. You are confusing the instrument with variable rate demand bonds which have a different structure and are placed to money market funds. Please revisit this piece to make those corrections.

Anonymous said...

Thanks for your offer; the CUSIP on the auction-rate preferreds for the closed-end fund is 278279401. Thanks again.

Accrued Interest said...

Looks like its auction is today. Last week the reset was 4.2%.

Anonymous said...

Thanks for checking last week's auction results for me for that closed-end fund's auction preferreds, AI. I enjoy your blog!

Anonymous said...

I'm an individual investor who knows enough to get myself in trouble. I really appreciated the post as I had been worrying about possible ripples into the Money Market sector from ARS. I'm relieved to know they are unrelated.

I do hold a few muni ARSs and was wondering if someone could tell me what the underlying credit of the issue is? I'm trying not to panic, but want to make informed decisions also. Is it an opportunity to capture some higher yield or should I flee for the exits (if that's even still possible)?

Here are the CUSIPs:

6579022K7
65820HVF7
658203XE9

They are all AAA insured through MBIA.

Thanks for any info on these.
-Dave

giftgivers said...

Many here felt that the original issuer may have same level of rating, but that may not be true in medium term.
I am quoting a more recent bloomberg report

"...rating company changed its credit outlook on states to negative from stable as sales, corporate and income taxes fall below forecasts. States will likely borrow more to fund programs, Moody's said. A downgrade can boost taxpayer borrowing costs as investors demand a higher return for increased risk.

Half of U.S. states, including New York, New Jersey and California, are projecting budget deficits next fiscal year amid the worst housing slump in 16 years. States that had robust residential real estate markets, such as Florida, Arizona and Nevada, have been particularly hard hit...".

It further says

"California Governor Arnold Schwarzenegger in January proposed across-the-board cuts of at least 10 percent to all spending to fill a $14 billion budget gap. Fitch Ratings last month said it may lower its rating on California's $49 billion of debt because of the deficit.

Moody's said that while states will encounter difficulties this year, the situation won't merit the number of downgrades that occurred during the 2002 economic slowdown because states are better positioned to deal with a budget squeeze.

`Advance Warning'

``States have had more advance warning of this downturn, as well as larger reserves,'' Moody's analyst Nicole Johnson said in the report. ``Many states are taking proactive measures and cutting spending before revenues are depleted to the point of drawing down on reserves, while others will draw down from the large cushion of reserves they built up in the last few heady years of the housing boom."

Of course, the bureaucrats from the local authority who has to go through all fine print, actually go through all this will determine their individual authority's real soundness. If they really read the fine print, dont you think they would look for work in the private sector not in public sector

Anonymous said...

I have an auction rate long term muni that failed last week and reset at 12%. Will I earn the 12% until and if the next auction passes? If the auction continues to fail, it sounds like I will earn the 12% until the muni refinances and pays off my bond or defaults. Is that correct? If I don't need the liquidity, the reset at 12% sounds like a good thing for me.

Chris said...

Hi,

Just found your blog by googling municipal auction rate bonds'.
You had the explanation I was looking for. And the site is impressive in it's geeekiness, which is a compliment. Unfortunately for me, the $25,000 share price is too much for me, otherwise I would happily allow a municipality pay me 20% for an undetermined period of time. Don't throw me in that briar patch !!

Accrued Interest said...

Anon: Yes you get the 12% for as long as the bond remains outstanding and the ARS problem persists.

Its looking increasingly like a deal on muni insurers is coming, which I think will help ARS.

Anonymous said...

How long can a municipality continue to make 12% payments without going into BK?

Accrued Interest said...

No one is going to allow the 12% (or 20% or 9%) to persist for very long. Municipalities just have too many options.

There are already billions of refinancing deals in the pipelines, so I'd say that within the next 3 months or so, there won't be much left of the ARS market.

Accrued Interest said...

Well, within straight munis that is. Asset-backed ARS are a different story, I'm not sure what happens there.

JP said...

The munciapl auction rate securities are not the major problem. The closed end fund auction rate securities are the problem. Their penalty rates are a small spread above libor. Not the high 10-20% penalty rates the municipals are paying. Who wants to own a closed end fund auction market security that pays 4% that can't be sold? The underlying bond is a perpetual long long term bond. Therefore, if you can't sell it at the auction or in the secondary, you are a long long term holder.

Anonymous said...

Easy solution -- fund company takes the high road and a) converts to open-end, thereby eliminating leverage and also eliminating discount or b) liquidates, making everyone whole instantaneously.

Amazing that nobody has caught onto this and voiced in a much more public forum -- quicker than all other remedies mentioned.

Are fund companies really entitled to lock up these assets and pretend as if nothing is happening?

Penny Auction Online said...

I am an auction lover. So every news related to the auction makes me very happy. Thanks for keeping us updated.