Friday, February 29, 2008

Auction Rate Securities: Hibernation sickness

Has all the good news on bond insurers improved the auction rate municipal bond market? Taking another look at the results of J.P. Morgan's auctions reveals that the ARS market is indeed thawing a bit. Morgan held 103 bond auctions on Tuesday, 47 of which failed. Looking a little deeper, however, and we see that all the failed auctions occurred where the bond had a relatively low "max rate." Remember that when an auction fails, there is some pre-determined rate at which the bond resets.

For example, some very strong credits failed on Tuesday, such as some New York Dorm Authority bonds with FSA insurance and a AA underlying rating. The failure had nothing to do with the credit, but for the fact that the "max rate" was only 4.688%. Holders of these bonds not only have zero liquidity, but an unexciting reset rate to boot.

Among the successful auctions, rates ranged from 4.00% to 10.24%, with a median rate of 6.755%. While these rate resets will not grab headlines like the 20%-type rates seen over the last couple weeks, 6.75% is still about 450bps higher than where money-market eligible munis are trading.

So while we might say the ARS market is starting to function on a certain level, there should be little doubt about its future. Municipal issuers are highly likely to refinance these securities over the next 3-6 months, either into traditional put-bond structures or long-term fixed-rate bonds. There may not be such a thing as an auction rate municipal market this time next year.

Worth noting that this doesn't seem to have anything to do with the improved picture for MBIA and Amabc, as the difference between failed and successful auctions seems to have everything to do with the available rate. In other words, it reads like there is capital available for non-liquid municipals as long as the rate is right. Insurance doesn't seem to matter.


Anonymous said...

yeah, i've saw rates of 8% last week and am seeing rates of over 10% this week - and yet not too many calls. seems surprising. (remember these are tax free rates). I imagine sooner or later the calls will come in. and yes, I agree that the market seems to be working again because of the high rates - not because anything else has changed. Isn't this a good sign - real rates going higher to reflect inflation ? more reflective of the "true" cost of borrowing money ... or the end of an era of cheap money

Anonymous said...

Hedge funds fit the bill as bidders using that approach. They are not so concerned about liquidity as they have lockup/redemption intervals and they go for the highest rates they can get (who wouldn't?). On the other hand there are hedge funds liquidating their TOB programs, flooding the market with LT muni supply.

Accrued Interest said...

I think there are hedge funds out there who have lines of credit where they can still borrow at LIBOR + something small. If you could borrow at LIBOR + 100, let's say, and buy a ARS at LIBOR + 500, that's free money.

But on the flip side, ARS can't get back to "normal" rates if those are your only buyers.

Anonymous said...

Where will this end?

Is there enough information to predict into the 2 year horizon?

Is anyone doing Bayesian analysis on this, because this is a very fertile ground for Bayesian statistics?

Time to predict the future.

blackswan said...

With the ARS collapse, municipalities that cannot afford to continue to pay high, pre-mandated auction failure rates on their underlying bonds, will have to call them and create new, lower interest rate instruments to take their places. Given a soft bond market, who will be the buyers of these new instruments? Will municipalities even bother with monoline insurance? Without insurance, how much higher will yields have to be?

Anonymous said...

Hedge Funds' Fire Sales Send Muni-Bond Yields To Historic High Levels
By Michael Aneiro, Tom Lauricella and Liz Rappaport

Months of turmoil in the municipal-bond market, long a placid haven for individual investors, reached a boiling point Friday -- as hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities.

As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond.

Anonymous said...

Perhaps part of the problem is the ever-declining US dollar. Even a tax-free rate of 8% might not be worth it if other currencies return more in US dollar terms, as they did in 2007.

There's also the specter of inflation to think about. You don't want to be earning 8% if inflation might conceivably be 10% in two years. Remember these are illiquid and unsellable securities, unlike regular bonds. You could be stuck with them for 30 years while your principal declines to near zero in real terms.

Another difference with regular bonds is that the muni tax break applies only for American taxpayers, so no deep-pocketed foreign bargain hunters will step up to take these things off your hands.

And there's little upside for bargain hunters anyways, because as Accrued Interest already pointed out in an earlier post, if and when credit turmoil ends, the rates go back down. This lack of upside means less liquidity.

flow5 said...

As long as the U.S. continues to run current account deficits, these deficits will inexorable force the dollar down in terms of its foreign exchange value – and no consortium of central bankers, treasury secretaries, et al. can stop the process.

These deficits are primarily the consequence of (1) a non-competitive economy – the U.S. needs to sell higher quality, lower cost, goods & services, (2) our dependence on imported oil, and (3) the Pentagon’s unilateral transfers to foreigners.

We are now currently selling our birthright for a mess of pottage. We are a financial hostage to the Pacific Rim, the oil exporting countries, etc.

Unless we are willing to make those fundamental reforms requisite to successfully competing in international markets, the continued decline of the dollar will finally force a payments balance on us.

Under these circumstances, we can expect long term deterioration in the standard of living of the vast majority of the people in this country.

Anonymous said...

How many people here are sick of hearing about auction rate bond failures?

The problem isn't liquidity or dubious AAA ratings or black swan events or regulatory failures.

The problem is that the United States is living way beyond its means.

Its pretty foolish to buy **ANY** fixed rate security denominated in a currency of a country that cannot pay its bills.

Some economists are whining about "buying time to work through the problem" -- but that is the same line that has been used for the last 30-40 years (since the U.S. was more or less forced out of the Bretton Woods system because we were living beyond our means).

AI has negelected to mention the most stunningly obvious solution to this ARS "problem"... just don't borrow the money. If you don't have the money right now, then don't spend it right now.

How obvious is that? It says a lot about the debt addiction (and it is an addiction) that no one even mentions this obvious solution. When you just cannot imagine your life without another fix (credit line) -- that's when you know you have a serious problem.

viking said...

hey flow (deepthroat),

you still thinking about long gold later this year?

where do you think spx goes from here?


Anonymous said...

And now the student loan issuers are paying 0% interest on their auctions owing to an obscure amendment allowing for a "maximum rate waiver". Watch the fur fly.....

Anonymous said...

Did you happen to see that California is going to offer munis without insurance? I know you posted about why its just tacked on, but interesting still. I need to read the story to see if they said why - only caught the headline.

Anonymous said...

Hello AI,

I have a question for you. I hold two ARS that are set at 4.6% after failed auctions. The max rates on them are set at the 90 day treasury rate + 120 bps or Libor +150 bps, whichever is lower. I think that these fall in between the high penalty rates that will be called or traded at auction and the super low ones where investors will certainly be stuck with them. What is the best course of action?
Thank you,

Accrued Interest said...

Sorry I can't answer all the questions posted here. Its a great conversation. I'll say to Anon talking about inflation: that's clearly not the problem when the 2-year is yielding 1.60%.

Issuers like State of California have often come with no insurance. Even when CA was rated BBB they could sell bonds with no insurance. Under normal circumstances, issuers usually saved money by buying the insurance policy.

What's questionable about insurance is why investors paid up for it, and continue to pay up for it. In other words, why did we take an A-rated school district in Indiana and insist on getting Ambac insurance on top? Why didn't investors want the extra 15bps or whatever in yield as opposed to paying it to Ambac?

flow5 said...


Buy a home in Costa Rica. I think the SPX will bottom in May or June because that's when I think short term rates will bottom.

I still think that last quarter will show the sharpest gains. This depends on the Fed's "front-end". Stagflation is at root here - but there will be some leeway to increase the money supply at year end.

Anonymous said...

For those looking for a place to sell your auction rate securities, I encourage you to visit the Restricted Securities Trading Network (RSTN) at The RSTN is the largest centralized secondary market for ARS. The firm I work for, Restricted Stock Partners, manages the RSTN. Alternatively, please feel free to call me directly at 212.668.3909 or via email at with any questions. Regards, Brendan O’Connor

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