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An Auction-Rate Pig by Any Other Name is Still a Pig

Posted by Larry Doyle on June 19, 2009 10:20 AM |

The brazen balls of both Wall Street and Washington know no limits. Hat tip to Kathy for pointing out to me that Wall Street is now running a new version of the Auction-Rate Securities play.

Recall that the Auction-Rate Securities fraud has left thousands of investors and billions of dollars frozen. While that fraud remains outstanding, Wall Street is calling an “audible” but at its core it is the same play. This smells!! Make sure you wear some heavy boots as we take a walk through the sty.

The Wall Street Journal highlights the particulars of this charade, New Security Shifts Risk to Borrower:

It didn’t take long for Wall Street to dress up an old idea and make it seem new again.

Wall Street firms including Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley & Co. have introduced a new security for the damaged municipal-bond market, meant to fill the role once played by securities that lost investor confidence in the peak of the market panic.

Their effort is part of Wall Street’s search for new ways to create business after a crippling nine months of crisis and government intervention. Much like auction-rate, variable-rate, and corporate floating-rate debt, the new tax-free “Windows” or “X-tender” securities offer municipalities the ability to borrow for the long term while paying only short-term interest rates.

This model proved dangerous during the credit crisis. Banks and bond insurers — who offered both express and tacit guarantees to backstop the debt — failed to live up to some of their promises. These securities became untradeable and dropped in value, leaving money-market funds in jeopardy of “breaking the buck.” Borrowers like municipalities, nonprofit institutions and student-lending companies faced penalizing interest rates well over 10% for months.

Like auction-rate securities and other variable-rate debt, the new instruments have an interest rate that resets every week, but this one is based on a short-term municipal debt index. The securities act like short-term debt and are appealing to money market funds that need to be able to sell their investments quickly.

This time, though, the banks removed some of the weak links from auction-rate securities and variable-rate demand bonds. Instead of banks or bond insurers acting as a guarantor or buyer of last resort at the auctions — which they were increasingly forced to do last year — the borrower itself promises to accelerate repayment. The borrower has seven months to repay.

Let’s review some of the driving forces and principles behind this new “Porky Pig” designated as “Windows” or “X-tender” securities:

1. Muncipalities are increasingly unable to finance themselves via the long term debt market. If municipalities can finance themselves, the rates are extremely high. This “pig” offers them a vehicle to sell into the deep, short term money-market arena with a “promise” by the municipality to repay these obligations if auctions fail.

2. The banks and brokers remain on the hook for tens of billions of dollars for not having lived up to the same ‘promise’ in the previous iteration of Auction-Rate Securities. That said, they are more than happy to facilitate this version and collect the fees for doing so.

3. Money market funds are flush with cash from investors who are increasingly risk averse. How will the funds that purchase these “pigs” market the fact that they are taking this degree of risk in the fund? Will brokers and managers fully highlight that fact, or will it be business as usual and keep the investors in the dark?

Wall Street and Washington are, once again, willing to oblige this version of a Ponzi scheme because there is lots of up front money to be made. The WSJ offers as much:

Despite the risks, the Securities and Exchange Commission blessed the instruments, allowing money-market funds to buy the debt.

Banks are also taking advantage of pent-up demand from municipalities that need money. Outstanding issuance of variable-rate debt has shrunk by approximately $100 billion in 2008 — a 20% drop, according to Municipal Market Advisors. The banks are now estimating as much as $10 billion in such “Windows” deals could hit the market over the next six months. So far, at least two municipalities have sold the debt and another deal is close to completion.

Sense on ¢ents strongly encourages investors to take the following approach:

1. Stay as far away from this product as possible. I am willing to bet this product will not be sold directly, but will strictly be ‘buried’ inside money market funds. Be careful!!

2. Ask your brokers or advisers if they are aware of this product; bring this to their attention!

3. If a broker or adviser is pitching a money market fund to you, make sure the fund does not have exposure to this garbage.

Oink, oink!!


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