Monday, February 18, 2008

J.P. Morgan's ARS Book: A lack of vision

Results of J.P. Morgan's ARS auctions Thursday were fascinating. 50 out of 93 auctions failed, with the "failure" interest rate ranging from 3.41% to 15%. The average among the "failed" bonds was 5.26%. Remember that if an auction fails, there is some mandatory "failure" rate, which varies greatly. My understanding is that a lot of student loan issues have relatively low failure rates, and that's borne out in the J.P. Morgan list. J.P. Morgan shows 12 failed student loan issues, one of which reset at 12%, but the rest reset below 6% despite the failures.

The failures are only half the story, though. Among the "successful" auctions, the average rate was 8.69%, with 14 "successful" issues resetting above 10%. That tells me there are buyers out there who are willing to buy these bonds, and are bidding just below the mandatory failure rate.

There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted. The City of New York (rated Aa3/AA) had three issues auctioned, all three of which were fully tax-exempt. The rates were 5%, 5.25%, and 6%. Energy Northwest, a municipal power provider in Washington State, which is rated Aaa/AA-, had their ARS fail, and got a rate of 6.23%. Meanwhile, at one healthcare institution with a Baa3 rating and Radian insurance had their auction succeed with a 4.67% yield.

Several dealers, including UBS and Merrill Lynch are publicly stating they will not necessarily support ARS by buying bonds at auction. As has been discussed, in the past it was common for dealers to step up and buy the ARS to prevent an auction failure. But right now the volumes of failing bonds are just too great, and capital is too constrained. I'm certain the dealers are worried about lawsuits, with investors claiming they were told the bonds could be sold at each auction date without question, which is of course not the case. I don't know how anyone is going to sue when no one has actually lost any money so far, but we'll see.

Meanwhile, I've received many e-mails from people interested in how one can play these ARS failures. One interesting idea is closed-end funds. Most closed-end bond funds are leveraged, usually in the 1.2-1.5x area, and they commonly use auction-rate preferred to create this leverage. Obviously if the ARS reset at 10%, and the fund is buying municipal securities which yield 4%, that's not a good situation. But let's think about closed-end ARS for a second. The closed-end fund has pledged its portfolio of bonds to preferred shareholders. Let's say its a $150 million portfolio of munis, $50 million of which was bought with proceeds from the auction-rate preferred (i.e., 1.5x leverage). But really that means the preferred holders are covered 3 times over: $50 million in debt covered by $150 million in assets. Really that's safer than any single muni issuer.

And yet closed-end muni funds are getting hammered, with several falling more than 5% today. I looked at the worst performers on the day, all of which had leverage created with auction-rate preferreds with 7-day auctions. The highest reset number I found was 3.3%. Excuse me if I don't panic.


Anonymous said...

Its great to make money off something that is mispriced (or that you believe is mispriced)... lots of people did that trading CDOs and Enron stock.

AI: There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted.

But to do it consistently, you have to understand **why** it is mispriced. If you don't understand why, than you cannot control your risk.

I have enjoyed reading your blog. Best of luck to you in the future

Momo Fader said...

A.I. what do you think of David Kotok's assertion that some of these muni CEFs may see 30% haircuts this year? Outrageous, or within the realm of reason?

Accrued Interest said...

Gramps: Are you leaving me?

Momo: I read his point, but I don't see how he gets to 20-30% on a straight muni fund. That would imply that a fund with like 1.3x leverage loses like 25% or so on its holdings. Homebuilder bonds haven't lost that much, generally speaking.

Anyway, like I said, I've looked at all the resets on these funds and there is nothing unusual. Most have "maximum" resets which are pretty low, often something like 110% of CP rates.

Momo Fader said...

I think the interviewer cut him off and misunderstood the point that Kotok was trying to make. I believe he was suggesting that some Muni CEFs could end up at a 20%-30% discount to NAV.

Anyone who has been around the CEF world knows how volatile they can get in a crisis. An intraday spike down to 20% or greater discount to NAV is certainly not out of the realm of possibility.

Look at something like VGM as an example. Right now it's at about 7% discount. For the sake of argument, let's say the NAV stays around $15, so a 20% discount would take the share price down to $12. That seems very possible, given that it was trading with a $13 handle in December. Especially since CEFs tend to lose all form of liquidity in a market sell-off.

I don't think the reset rate on the ARS portion of these CEFs will alone cause the problem. The problem will be exacerbated by a loss of confidence in the instruments in the retail market, and failure at multiple levels of backstop in the institutional and bank markets. That's what I think Kotok is driving at. Some of the leveraged CEFs may be forced to unwind their leverage.

I'm short Eaton Vance, given this mess, as I can't see how their expenses will not go up nor how their assets under management will not go down this year.

TD said...

I have read that some failure rates are set as high as 20%. That sounds like a no-brainer on assets backed by AA credit. I am not an expert in the area. Am I missing something?

Anonymous said...

I have read that some failure rates are set as high as 20%. That sounds like a no-brainer on assets backed by AA credit.

There are a couple of gotchas...

- Its almost impossible to get financial data on the issuers of these securities

- AAA isn't what it used to be

- For issuers with good credit, the high yields may only last until the ARS market unfreezes

- The bonds are fully callable so if the ARS market never unfreezes the issuers will simply refi

The result is that there is little upside if you hold the "sheep" because market yields will quickly collapse or the issuer will refi.

But, if you're unlucky enough to hold a "goat" you'll end up with a 30 yr bond trading at well below par.

Anonymous said...

Well, looks like the lawsuits have started with the ARS auction failures. Bloomberg is reporting this morning that Massachusetts and Ohio are requesting closed-end fund companies to disclose information about failed auctions that left investors unable to sell their holdings "...which were billed as the equivalent of cash."

As Tom has written here, the ability to sell out of these securities at par was never guaranteed, so it will be interesting to see how this investigation and potential legal action will pan out.

Fun quote from the article: "'I wanted something as good as cash, and now I've got a lot of money in there that I needed to get at quickly,' Aaron E. Some, an investor in Delray Beach, Florida, said in an interview yesterday." Apparentlu Mr. Some has around $4.5 million tied up in ARS, where he probably should have stuffed it in a money market fund...


Accrued Interest said...

My bet would be that the sales people who sold the ARS are more liable. But its hard to sue someone when no one has lost any money.

Anonymous said...

I exited my ARS positions a few months back out of concern that this sort of illiquidity was in the offing. I might have held them if my broker could have told me what the failed-auction interest rate was. My reasoning was that if liquidity failed I could be stuck with the bond for a long holding period, generally a bad idea unless the interest rate is very high. This is a big problem for ARS buyers - there are so many issues with so many different terms, even knowing the underlying credit quality is not enough.

Anonymous said...

From Bloomberg: "Yesterday's 641 auctions of publicly offered bonds resulted in 395 failures, or 62 percent,"

Anonymous said...

To me, the issue isn't the failure reset rate, which as you mention is still low enough for the CEFs to make money on the spread.

The issue is that the auctions are continuing to fail, and will likely to continue to fail. At some point, the CEFs will have to make the preferred holders liquid.

They will either delever or they will change the way they borrow. If they delever, they'll be dumping something like $200B in illiquid munis on the market.

Unlikely to happen, but that would be an interesting opportunity.

Anonymous said...

Your comment that no one will sue because no one has lost any money is correct vis-a-vis the issuer. The lawsuits will be agianst the brokers and financial advisers who told clients that ARPs are "cash" that would be accessible immediately. I'm told Wachovia is forestalling this eventuality by letting auction rate holders borrow against these secutities just to get cash - even though they're unmarginable.

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.