THE CURRENT AUCTION RATE SECURITIES MARKET
The Auction Rate Securities ("ARS") market has been experiencing an unprecedented breakdown in liquidity via massive failed auctions. These auction failures have resulted in the ARS resets to leap to the penalty rates as high as 15% for some issues. Bondholders of a failed auction are unable to sell their securities through the normal auction procedure. For many of the bondholders, that desperately need access to cash, the high rate received under the failed auction is bittersweet because they cannot recover their principal. For other investors that do not need cash right away, these developments have proved to be a boon as they are achieving an outstanding return on capital for, in most cases, little credit risk.
WHAT IS THE COST TO TAX-EXEMPT ISSUERS?
The malaise in the ARS market threatens to cost tax-exempt issuers hundreds of millions of dollars per month if current market conditions persist. While there are varying reports on the exact size of the tax-exempt ARS market, the total ARS market (i.e., taxable AND tax-exempt) is estimated at $330 billion. Making a conservative assumption that only half of the ARS market is tax-exempt would imply $165 billion of these toxic variable rate securities. For every point (1%) that the yield of the ARS increases, the tax-exempt issuers are out $1.7 billion annually ($138 million per month).
In order to appreciate the scope of the problems in the ARS market it is important to understand the alternatives available to tax-exempt issuers. Variable Rate Demand Bonds ("VRDBs") are a common type of variable rate bond issued in the tax-exempt market and are a viable alternative to ARS for most issuers. The ARS market developed rapidly over the past five years but is nascent compared to the VRDB market which has been around since the mid 1980s. The SIFMA ARS Index (a weekly tax-exempt variable rate index that tracks the ARS market) has averaged 3.76% over the past four resets while the SIFMA Swap Index (a weekly, tax-exempt variable rate index that tracks the VRDB market) has averaged 2.80%. This spread of 0.96% (SIFMA ARS Index less SIFMA Swap Index) is a good measure of the relatively higher cost of ARS to other variable rate alternatives for tax-exempt issuers. There are other factors that also play into the net cost to issuers such as the ongoing support fees associated with the different variable rate products (e.g., broker-dealer fees, liquidity fees, remarketing fees). Under current market conditions, assuming an insured variable rate bond offering, the fees associated with VRDBs would be higher by approximately 0.15% to 0.25%, which would cut into the 0.96% benefit calculated earlier. With the adjustment for the support fees included the ARS market appears to be costing tax-exempt issuers 0.71% to 0.81% which equates to $1.2 to $1.3 billion annually ($98 to $112 million monthly).
WHAT CAUSED THE PROBLEMS IN THE ARS MARKET?
Whenever money is lost, and especially when a great deal of money is lost, our petulant society is quick to seek an outlet for its wrath. Who is responsible for the frozen ARS market? Is there someone that was too greedy and now needs a good thrashing?
The ARS market freeze was not caused by a single event or a single firm. There were, in fact, a few major events occurring simultaneously that resulted in the dire market results. Those were:
1) Loss of Faith in Monoline Insurers
The ARS market has always been a highly credit sensitive place. Well over 90% of all ARS issues were AAA rated prior to the faltering of the insurers. Insurance was almost a requirement for issuers with only a few highly rated entities entering the ARS market without the support of a monoline insurer. The loss of faith in the insurers would have had a major detrimental effect on the market even if none of the other events listed below occurred.
2) Broker-Dealer Writedowns and Losses
It was standard practice for broker-dealers to use proprietary accounts to place bids in order to avoid failed auctions. This practice is described in the May 31, 2006 SEC settlement with 15 of the broker-dealers that participate in the ARS market (the news release can be seen here http://www.sec.gov/news/press/2006/2006-83.htm). The ARS market appeared to be more stable than it actually was. The writedowns and losses affected the market by eventually preventing the broker-dealers from bidding on the auctions to prevent their failure. As the credit crises worsened, the broker-dealers no longer had an adequate balance sheet to bid on the auctions and they were forced to watch them fail.
3) Cash is King
The general effects of the credit crises eventually came to bear down on the short-term municipal market. Many corporations invested heavily in the ARS market as a place to park their cash. Given the rarity of failed auctions prior to the credit crises, the ARS investors were comfortable with the auction procedure as a source of liquidity. Even though the ARS lacked a hard put like a VRDB (VRDBs can be put back to the issuer on any interest payment date by the investor at par), ARS investors accepted lower rates on their than a VRDB from the same issuer. As the credit crises progressed the corporate money managers began to feel the strain of the corporation's need for cash. Once the first few auctions failed there was a panic amongst these buyers and everyone was running for the exits only to find the doors chained shut.