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Auction-Rate Securities and Municipal Market Dislocation

Posted by Larry Doyle on January 13, 2011 9:39 PM |


The demise of the $330 billion auction-rate securities market may have culminated in February 2008 but the impact of that reality continues to be felt today. How so?

Large segments of the ARS market provided financing for a wide array of municipal entities. How did those municipal entities receive financing when the ARS market froze? Reports indicate that bank letters of credit (LOCs) provided ongoing financing for many municipal borrowers. Now what?

As those LOCs are rolling off, banks are extremely reluctant to roll them forward and impending default is staring many of these municipal borrowers right in the face. The capital markets are not anxious to provide liquidity and banks are equally reluctant. Thus while the Federal Reserve throws support behind many market segments, the municipal market has retraced back to levels last seen in early 2009.

The Wall Street Journal sheds further light on this dislocation within the municipal market in writing, New Hit to Strapped States,

With the market for municipal bonds tumbling, cities, hospitals, schools and other public borrowers are scrambling to refinance tens of billions of dollars of debt this year, another sign that the once-safe market is under duress.

The muni bond market was hit with the latest wave of bad news Thursday, prompting a selloff that sent the market to its lowest level since the financial crisis. A New Jersey agency was forced to cut the size of a bond issue by about 40% because of mediocre demand, and pay a higher rate than expected. And mutual fund giant Vanguard Group shelved plans for three new muni bond funds, citing market turmoil.

Yields on 30-year triple-A rated general obligation bonds shot higher to 5.01% on Thursday, reflecting a spike in perceived risk, according to Thomson Reuters Municipal Market Data. The last time those bonds yielded 5% was Jan. 30, 2009, during the financial crisis.

Amid the selloff, public borrowers such as states and utilities face a wave of refinancing stemming from deals cut mostly during the crisis. The deals involved letters of credit from banks that were designed to keep financing costs down for government entities in need of cash.

Though the financing deals can be meant to last decades, the letters of credit underpinning them are expiring sooner. That could force the borrowers in many cases to pay higher interest rates or seek guarantees at higher costs. For the weakest borrowers, new guarantees may not be available and refinancing too costly. There are about $109 billion worth of letters of credit and similar guarantees expiring this year, according to Bank of America Merrill Lynch. Some $53 billion in letters of credit alone is expiring this year, according to Thomson Reuters.

“Municipalities may be hard-pressed to come up with this money or refinance this debt,” said Eric Friedland, a municipal analyst at Fitch Ratings. The ratings firm is scouring to identify risks among weaker municipalities that are seeking to renew these deals, and says it could downgrade some.

The rollover rush stems from the credit crisis that roiled the U.S. in 2008. Municipalities had issued so-called auction-rate securities, instruments whose rates reset at weekly auctions. Amid the credit crunch, buyers at these auctions vanished.

The auction-rate securities market not only scammed investors but in the process provided financing to entities at interest rate levels which did not appropriately price the inherent level of risk. That fact is now coming home to roost and investors are responding rationally in forcing these borrowers to pay higher rates to gain financing.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own and not those of Greenwich Investment Management. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • coe

    LD – Given the likely inevitable responsibility of the federal government to backstop the states and local municipalities to insure some level of basic safety and security and social welfare services, is it just possible that those banks who have participated in the TARP support system and/or other Federal crisis programs that helped them during their hour of darkest need can be “persuaded” to extend letters of credit to the municipalities in their footprints in crunch time? I’m not saying that the banks need to subsidize pricing given the deterioration in credit, but there is a price at which the risk can be borne. We are talking about the availability of liquidity, first and foremost. Seems that might assuage some of the investor fears. Just a thought

    • LD

      Dear Sir,

      To put some degree of perspective into this madness, we should remind readers that the ARS market was a $330 BILLION market. The financial media has NEVER truly exposed the nature of that market and how SO MANY tens of thousands of retail investors got scammed and remain holding these securities.

      The ARS market did provide funding for long term debt on hospitals, schools, student loans, sewer facilities and more via the short term market. However, there is no doubt that many of these entities NEVER would have been able to access the market for liquidity without the ARS financing. One might say the ARS market provided a valuable service BUT the truth be told the ARS Ponzi-style financing mispriced credit and now so many of those retail investors remain unable to access their cash.

      I would not be surprised if selectively the Fed does manufacture another back door bailout, this time for selected municipal entities, under the guise of the banks extending LOCs. Your point is well stated.

      ….BUT what about those ARS investors who are effectively still financing many of these entities, despite the fact that they thought they were making “cash surrogate” investments? They remain largely screwed.

      • coe

        You have written often and passionately about this is virtually incomprehensible that so many individuals are trapped and suffering because the financial institutions that peddled this stuff just refuse to do the right thing ..the fact that the regulators and financial press and even the popular media haven’t taken up the cause is similarly bizarre..why do people flock to eat-up Rex Ryan’s foot-fetish, and yet go tone deaf to the ARS story.

        There wasn’t nearly the same apathy toward the Madoff scandal…once again seems that there is a dispassionate “get out of jail free” card for the institutions – and that matters of finance are somehow too complex and too headache-inducing to address.

        • Kathy

          I take seriously the question of how a $336 billion scam lives below the media/government radar.

          How does it happen that everyone — the investment banks that wrote these shady deals, the funds that sit with captive money, the federal government, the financial media — everyone pretends there is no $336 billion elephant in the room?

          State regulators took it seriously for awhile, then they too moved on.

          Is it that everyone shares the guilt, so no one points fingers? There must be a reason why $336 billion gets ignored.

        • Bill

          “financial press and even the popular media haven’t taken up the cause is similarly bizarre…”

          Course, the reason they haven’t is because the perpetrators of this scam are their advertisers.


    What is rocking the muni market? Further color from The Bond Buyer from May 2009 highlights how the failed ARS market is now impacting the muni market:

    One source who did not want to be identified estimated that the Fed would likely need to provide liquidity for $150 billion to $200 billion of VRDOs. That would cover municipal issuers still seeking to convert consistently failing auction-rate securities into variable-rate mode as well as provide sufficient liquidity to issuers with existing VRDO liquidity facilities from troubled banks. The precise size of the VRDO market is not known, but it is thought to be about 18% or 20% of the overall $2.7 trillion muni market, sources have said.

  • divvytrader

    <> Federal law prohibits giving certain states aid to pay thyeir grocery bills . Why is it all the states deepest in trouble are all the highest taxed states in the country ? Any connection ? Why do they all have the largest state worker to taxpayer ratios in the country ? any connection ? The snaswer is simply ….force these states to match average worker pay levels and numbers of workers per taxpayer as the rest of the country .

  • Seldom does one get to say, “I wrote the book on this subject,” that is, the ARS scam. The book, by the way, is titled RUTHLESS, and it is advertised on this site. Reading it will answer many questions.

    But for now allow me to explore in this abbreviated context the irksome matter of general media “indifference” to the ARS scandal:

    While writing the book, I spoke with many business editors in the mainstream media and pressed them on the paucity of coverage. The most succinct and frequent response was, “It’s a ‘rich man’s’ problem.” Ergo, “average consumers” would presumably show little interest.

    By and large, editors viewed the ARS debacle as a headache for elites, this based on the fact that the ante going into the market was $25,000. In addition, when the market was opened 20 years ago, the ante was $250,000, a figure which reinforced the “rich man” mantra. It was only when cracks began to show in the auction market that banks and brokerages reached out to retail investors by lowering the ante to $25,000.

    Please understand that a number of stories detailing the market collapse and subsequent developments were in fact reported by Gretchen Morgenson of the New York Times, Daisy Maxey of Dow Jones News Wire, and others. Money magazine published a few articles. Andrew Ross Sorkin of the NYTDealBook also pitched in. These reporters deserve much credit for pursuing a story that was hardly in favor among their editors.

    The 2008 meltdown, of which ARS was a part, overwhelmed the media. The financial chaos was so deep, so complex, and so frightening near; virtually overnight, the ARS problem was tossed into the shadows. Meanwhile, the media needed to find a proxy to stand in for the near-incomprehensible magnitude of the larger fiscal disaster, which included Lehman, Bear, AIG, among others. That proxy turned out to be Bernie Madoff. He was “human interest” fodder, emblematic of the larger picture. Such was the editorial judgment.

    Over time, I found there was a dismissive, if not contemptuous, attitude toward ARS investors. “They should have know better,” was the insult du jour. “Why didn’t they read the prospectus?” Well, there was no prospectus, but many editors found this hard to believe. In short, the retail investors were unfairly viewed as simple dupes, despite the fact that many large corporations and pension funds were invested in the ARS mix.

    As to legislators and regulators: Rep. Barney Frank’s House Financial Services Committee held hearings. All of the major regulators were questioned extensively. But despite overwhelming evidence that SEC, FINRA, and others had done little to fix the ARS problem, the committee failed to act; it provided no remedy for the $336 billion elephant galumphing around the hearing room. Help, when it came, was a product of state securities regulators whose constituents could apply political pressure.

    I asked Rep. Frank why nothing but talk came out of his committee hearings (which reminded me of Kabuki theater). “We were overwhelmed,” he replied. The financial sky was falling and the regulators were ducking for cover, this in a political atmosphere in which deregulation was king of the hill.

    During the writing of RUTHLESS I had lunch with one the Bush administration’s top appointees. He confessed that President Bush was aware of the ARS debacle and, like the former SEC Chairman Christopher Cox, the president believed it was best to “leave it to the market” to find a solution. (You can read about this bizarre luncheon exchange in the book.)

    So here we are with $200 billion in ARS redemptions, and anywhere from $120 to $130 billion still under challenge. A disgraceful situation!

    We now have a new administration and many new faces in congress. Will they act to make ARS investors whole? Don’t count on it. A fix will not come from Washington. It will require considerable pressure from state regulators to bring this long-standing scandal to a conclusion.

  • fred

    As reported in the FT:

    U.S. Public pensions face a funding deficit of $2,500bn, and as with their federal counterpart social security, public pensions are not included in the reported state and municipal debt figures.

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