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.