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.
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.