Tuesday, August 12, 2008

Auction-Rate Securities: You are now mine!

Several banks/brokers, lead by Citigroup, have either reached a settlement regarding auction-rate securities (ARS) or are offering to repurchase the securities from customers. As of this writing, Merrill Lynch, Morgan Stanley, and UBS are among those ready to buy back at least some ARS from customers. Several others are either in negotiations with the New York AG or remain part of the inquiry.

Citigroup's settlement states the bank will purchase approximately $7 billion in ARS which are currently not clearing from individuals, small institutions and charities. The announcement on Thursday immediately sent Citi's stock down 4%, and pushed the shares of other major municipal bond dealers sharply lower as well.

There is a key element of this that hasn't been well reported. A very large percentage, something like 80%, of the true "municipal" auction-rate securities have either been refinanced or are actually succeeding at auction. Most of what's left are related to student loan financings. In a typical student loan securitization, a trust is formed which holds the actual loans. The trust then sells securities to the public. This trust is bankruptcy remote from the originator of the student loans. So if Citigroup arranged your student loan, they probably put it into a trust labled Student Loan Corporation. The loan is then considered off Citi's balance sheet.

Very few student loan auction rate securities (SLARS) have been refinanced. This is because the trust which issued the SLARS has no incentive to refinance. Or more precisely, there is no real decision maker for the trust, at least in terms of their outstanding debt. In addition, SLARS typically have relatively low maximum coupon rates in the event of an auction failure. Without a tight limit on the rate, it would be possible for the SLARS to carry a higher rate than the underlying student loans.

So now Citi (and others) are going to need to find a way to create liquidity in these securities. Unfortunately with many SLARS, a simple refinancing, even if Citi were willing to somehow subsidize the transaction, may not be possible. Its also not realistic for Citi to just starting making a market in the ARS and assume liquidity will follow. In other words, Citi cannot just go back to their market-making role of years past. Investors will be once bitten, twice shy this time around.

So this is going to take some creativity. You can bet that Citi already has legions of investment bankers working on structuring something to create an out. Perhaps some sort of resecuritization where Citi puts a series of these SLARS into yet another trust and then sells bonds with a legal put to fund the trust.

Either way, its good news for investors stuck in ARS. It should free up some cash which will most likely flow into short-term municipal bonds. Ultimately it should be something with which Citi (and other dealers) can handle liquidity wise. Remember that student loan ABS are eligible collateral at the discount window and the TSLF, and most of the underlying loans are government-backed. But it will be a distraction.

9 comments:

Kurt Osis said...

Ok let me preface this with: I don't actually understand how CDS works.

I always thought of it as put on a bond struck at par married to a stream of cash flows of the same maturity.

Can I continue to think this way so my head doesn't explode and just say to myself that discount rate (for theoretic value of the put as well as the cash flow stream) is YTM of the reference minus LIBOR?

Second, again, given that I don't understand CDS: why can't lehman solve its liquidity problem by just writing large amounts of CDS on all of the other banks and exchanges, chances are if the reference bond from these better capitalized firms are in default, lehman will have already failed anyway. If Goldman is defaulting (and they're in control quasi control of the treasury department) what're the odds lehman is still around anyway? in the mean time Lehman gets the liquidity they need and when the credit markets die down they can unwind the trades on the cheap.

To put it another way, isn't there an arbitrage opportunity in financial institution CDS because it only prices the conditional probability that a major institution will fail given that the CDS market itself is still functioning?

To put it a third way, Lehman needs to monetize the Bernanke put to raise capital.

arb-it said...

I don't know anything about muni ARS, but I have some experience with ARS embedded into ABS CDOs (talk about the center of the hurricane!).

ARS were created in these securities to take advantage of the yield curve and finance some of the higher rated tranches at a lower rate. In the SPV created for the CDO, there is no mention of an auction, the tranches were created as floating rate securities similar to any other deal. There was a separate set of documents that dealt with the auction, how people participated, maximum and minimum spreads and the fail rate.

The whole game is a way to take long term debt and price it like short term debt. The auction process is supposed to mimic a short term auction process. But the difference is that if a short term auction fails, the debt isn't distributed, while in ARS, the debt remains with the debt holders.

And here's the really bad part, if an auction fails, the only way to trade is in the secondary market where it is priced against comparable long term debt. So the mark to market hit is two fold, one on the difference in duration (1/4yr vs 6yr) the other is the spread on the ARS (even at the fail rate) is less than a comparable long term security.

So what the banks have to do is buy the ARS back at par, and then eliminate the auction, turning them back to floating rate securities and then take a huge hit on the mark to market.

Accrued Interest said...

Kurt:

A CDS is similar, at least in its most basic form, to a put.

What you are describing is a chaos trade, and Bear Stearns had this trade on. Didn't save them.

I'll be surprised if Lehman fails. I won't be surprised if they accept a $20ish buy out offer from a stronger partner. Or if they sell Neuberger and then slowly drift off into irrelevance. But I don't think they wind up failing.

Kurt Osis said...

Yeah, it shouldn't necessarily save them, just allow them to synthetically borrow money at LIBOR. (i think) And keep the debt off the balance sheet.

Obviously even carried to perpetuity that trade has a maximum expected value beyond which if Lehman's capital needs still exist they'd have to raised additional capital to the extent possible. However that doesn't mean you'd leave the money on the table, obviously Bear raised additional equity to no avail but that doesn't mean banks no long bother raising equity.

Accrued Interest said...

Basically I think Lehman has plenty of liquidity. But in order to really run their business, they need unquestioned liquidity. Not "I think they have plenty."

I think the end game is for them to finally sell a very large chunk of what the have in commercial and residential MBS. That's the only way they quell the rumors.

Then the question becomes whether they have enough of a balance sheet left to survive on their own. That's an unknown right now.

PNL4LYFE said...

One key difference between selling CDS and writing puts is that most option sellers receive the premium upfront. CDS on companies with low credit spreads (anything less than around Libor+800bp) trades with no upfront payment. In other words, Lehman could write as much CDS on Goldman, BofA and the like and not receive any cash today. It would amount to "free" earnings over time as they collected quarterly coupons without having to pay any claims in default.

DogFace said...

We're now up to 5 ARS settlements: Citi, UBS, MS, JPM and Wachovia. Together, those firms will buy back something like $50 b of ARS. But what's going to happen to the securities that are in those firms' ARS programs but were sold by other firms. Do they get bought back, too?

Accrued Interest said...

No. If you bought an ARS from someone like Raymond James, unless RJ settles, you aren't directly helped.

And I don't see liquidity improving in any meaningful way for low max stuff, especially studen loans.

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.