Auction Rate Securities

Auction Rate Bond Market Faces Uncertain Future

Auction rate securities (ARS), investments once considered as safe as cash, are the latest victim in the fallout of the subprime mortgage collapse.

Auction-rate securities are long-term corporate bonds, municipal bonds and preferred stock on which the interest rates are reset periodically — typically every seven, 14, 28 or 35 days — based on bids submitted through securities firms.

In the past, auction-rate securities have been popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other not-for-profit entities because of their low financing costs and the fact there are usually fewer parties involved in the financing process and no requirements for third-party bank support.

Holders of auction-rates securities are allowed to sell them on the days in which the interest rates have been reset. The problem now is finding buyers, as the $330 billion auction-rate securities market experiences turmoil and uncertainty like never before.

Historically, auction-bond failures are rare. But in recent weeks, increasing concern regarding the credit strength of insurers backing the underlying debt obligations has led to a rapid decline in demand for the securities. Adding more fuel to the fire is the reluctance of banks like UBS, Citigroup and Goldman Sachs to submit bids in fear they could be at risk of holding too many bonds.

As reported in a Feb. 13, 2008, article by Martin Braun on Bloomberg.com, nearly half of the $20 billion in securities that went up for auction on Feb. 12 failed to generate interest among bidders. As result, no securities were sold. Merrill Lynch has gone on record that it plans to reduce purchases of any auction-rate securities that fail to attract enough bids from investors. UBS goes one step further — it will not buy the securities, period.

Why the failure?

The failure of the auctions can be traced to investor concerns about the credit ratings of the bond insurers that back the securities. When an auction fails, issuers are forced to abandon their offerings. Or, they have to pay exorbitant interest rates, which is exactly what the Port Authority of New York and New Jersey recently had to do.

Although the interest rate on the $100 million of bonds that the Port Authority of New York and New Jersey sold during the week of Feb. 4 was only 4.3%, the rate more than quadrupled, ultimately soaring to 20% on Feb. 12.

A similar dilemma confronted the state of Wisconsin at its 28-day auction of taxable bonds on Feb. 12. Bonds that the state sold at 4.75% on Feb. 7 jumped to 10% five days later. Shortly after Ambac Financial Group, the insurer of student loan debt issued by Vermont's Student Assistance Corp., lost its AAA credit rating, the interest rate was reset from 5% to 18%.

Other bond auctions have failed outright, including bonds issued by Presbyterian Healthcare in Albuquerque, Georgetown University, Nevada Power and New York State's Metropolitan Transportation Authority and Dormitory Authority. According to New York Times reporters Julie Creswell and Vikas Bajaj, nearly 1,000 auctions failed during the three-day period between Feb. 12 and Feb. 14.

Bond-auction failures can have a devastating effect on the issuers, whose only alternative is to pay the higher interest rates or cut back on their programs. For not-for-profit entities, which depend on these instruments to raise funds for their institutions and programs, and municipalities that are forced to raise taxes to meet higher costs of borrowing, the consequences are even more severe.

In the wake of reduced tax revenues from a weakened housing market and a potential recession on the horizon, many state and local governments are increasingly worried about how they will pay their bills while still offering essential services. Michael Quint reported in Bloomberg.com on Feb. 15 that the Municipal Securities Rulemaking Board, which is the top regulator for the U.S. bond market, "is so concerned by the chaos in the auction-rate bond market that it plans to seek comment on whether dealers in these securities should reveal the number of bidders, and disclose how often these auctions fail."

Reportedly, the Securities and Exchange Commission (SEC), which reached a $13 million settlement in 2006 with 15 investment banks involved in bidding irregularities, also is considering whether to require increased disclosure regarding the auction process.

Investors in these securities are no doubt feeling the sting. Individual and institutional investors that purchased the bonds — believing they were safe, low-risk securities equivalent to cash — now find themselves holding an investment for which there is essentially no market.

As a result, legal action already is brewing by several investors against the brokers responsible for selling the securities. Case in point: Merrill Lynch is a defendant in a Texas dispute in which Metro PCS alleges the firm misrepresented the risks involved and the suitability of the securities under the company's guidelines. Another case is Lehman Brothers, which is the respondent in a FINRA arbitration complaint filed by two wealthy New Jersey brothers who allege that the firm's investment of $286 million in auction-rate securities was inconsistent with the claimants' stated investment objectives.

Should I Sell My Auction Rate Securities?

Auction Rate Securities holders are asking whether they should sell their illiquid holdings or should wait in hopes of their auction rate securities being refinanced or redeemed. Unfortunately, there is no one answer that is right for every investor. This article attempts to discuss various factors that investors may wish to consider in making their own decision. Among other things, we discuss the status of the market, describe relevant considerations and discuss the advantages of selling and of waiting. We also provide investors with information on what they can do if they are interested in selling their auction rate securities.

General

In determining whether to sell their illiquid auction rate securities, investors need to remember that no one can predict the future. It is important to appreciate that while things could improve in the auction rate securities market, they could also get worse.

An individual investor's decision on whether to sell or to hold may be influenced by a variety of important factors. For example, the investor's need for liquidity in the foreseeable future, the investor's desire to eliminate risk, and the investor's personal perspective of the future are among important factors that may well influence the investor's ultimate decision.

Status of Market

A review of recent developments in the auction rate securities markets may help an investor make an informed decision about how to handle his or her own holdings. Recently, there have been some auction rate securities that have been redeemed or refinanced and it is anticipated that additional redemptions or refinancings will occur in the future. An investor should remember that there are significant differences among the various types of auction rate securities that impact the likelihood of refinancing or redemption.

At present, it appears unlikely that the auction rate securities market will ever return to the way it was. Several firms, including UBS and Citigroup, have expressed views that the auction rate securities market is dead.

Municipal auction rate securities have been refinanced at a much quicker rate than other types of auction rate securities. This has occurred, in large part, because many municipal auction rate securities have higher penalty interest rates when auctions freeze. As a result, there is a much greater incentive on the municipal issuers to refinance to avoid higher, and in some cases burdensome, interest obligations. Recently, Bloomberg News reported that slightly over 50% of all municipal auction rate securities had been redeemed or refinanced, but that the trend appears to be slowing. Capital Advisors Group has estimated that, ultimately, approximately two-thirds of outstanding municipal auction rate securities will be redeemed or refinanced.

Investors in auction rate preferred stocks issued by mutual funds have also experienced some success in having their auction rate securities redeemed or refinanced. Unfortunately, issuers of auction rate preferred stocks have not generally experienced the high penalty interest rates when their auctions failed so they have had less incentive to redeem or refinance their auction rate securities. According to a recent Bloomberg News report, approximately 30% of auction rate preferred stocks have been refinanced. It is important to note that it is anticipated that ultimately there will be additional redemptions or refinancings but that there will also be many auction rate preferred stock issuers that decide not to refinance at all. Capital Advisors Group has estimated that, ultimately, approximately 50% or so of the auction rate preferred stocks will be redeemed or refinanced. In evaluating this portion of the market, it is important to consider that there has been a lot of talk about refinancings but there are still various uncertainties attendant to such refinancings or redemptions. For example, some issuers have decided to only redeem a portion of their outstanding auction rate preferred stocks. The question remains open then what happens to the portion of auction rate preferred stocks that are not redeemed. Similarly, some issuers have issued statements that they intend to redeem portions of their outstanding auction rate preferred stocks but that such redemptions are dependent upon novel financing arrangements, the ultimate success of which remains unknown at the present time.

Student loan auction rate securities remain relatively illiquid. There have been few refinancings and it is generally believed that most issuers of student loan auction rate securities have little incentive to refinance or redeem their outstanding auction rate securities. This is true because there are cap rates on the amount of interest that student loan auction rate securities can pay. Thus, issuers of student loan auction rate securities do not face the high penalty rates facing some other issuers. As of this date, less than $3 billion of student loan auction rate securities (out of $85 billion of student loan auction rate securities outstanding) have been redeemed. Capital Advisors Group believes that, absent intervention by the federal government or a global broker-dealer settlement, liquidity is a long way off. Similarly, in a recent report, JP Morgan analyst Alex Roever concluded that investors may be stuck with as much as $70 billion worth of student loan auction rate securities. He stated: "Current investors are at risk of having to hold positions until maturity, which in a few cases may be almost 40 years away."

The most illiquid portion of the auction rate securities market remains those auction rate securities issued by CDOs or other structured finance vehicles. Many of the issuers of these securities have suffered significant adverse financial developments and their ultimate refinancing or redemption is regarded as unlikely.

Considerations

There are various factors that a prudent investor should consider in reaching his or her ultimate decision. Some of these considerations are economic, some relate to the individual's own financial condition, and others relate to the investor's future intentions, and the future intentions of the issuer of the auction rate securities.

Liquidity should be an important consideration for most investors. Does the investor need liquidity in the foreseeable future? Remember that auction rate securities are long term instruments and the investor must decide of he or she is willing to hold for the long term. If the investor needs liquidity in the foreseeable future, serious consideration should be given to selling the position. ";A bird in hand is worth two in the bush."

The investor's expectations for future developments in the economy may also play a significant role in the investor's decision. Obviously, things could get better, but things could also get worse. It is possible that issuers will be better positioned financially to redeem or refinance their auction rate securities in the coming months, but it is also quite possible that issuers may be in worse economic conditions and less able to refinance or redeem such securities. Similarly, future economic developments could result in prices in the private resale auction rate securities market going up or going down. Each investor needs to consider how much they want to eliminate future risks.

It is important for investors to consider the plans of the issuers of the auction rate securities. Investors should seriously consider contacting the entity that issued the auction rate securities that they hold. What are the issuer's plans? What are the issuer's time parameters? What are the contingencies attendant to the issuer's plans? Most issuers should be willing to share their future intentions with auction rate securities holders. Recently, one of our clients (after being told repeatedly by a brokerage firm that his auction rate securities would be redeemed) contacted the issuer only to learn that the issuer had no plans to redeem the securities.

Investors may also want to consider the future availability of viable options for disposing of illiquid auction rate securities. At present, there is a private resale market (discussed herein) where many illiquid auction rate securities can be sold. There is no certainty, however, regarding how long this market will exist or at what prices auction rate securities may be sold. Several months ago, one of our clients obtained bids to purchase his auction rate securities but elected to wait. Recently when the client decided to sell these securities, there were no bids. The client could not sell.

The investor also may wish to consider the current penalty interest rates that the issuer is paying. If the rate is satisfactory to the investor and the investor has no need for liquidity in the foreseeable future, it may make sense for the investor to hold the investment and view it as simply a supplement to income in coming years.

Investors may also want to consider their own plans and whether they wish to pursue legal action to recover damages that they have sustained as a result of their illiquid auction rate securities positions. Investors' attorneys believe that most investors in auction rate securities have compelling claims to recoup the damages which they have sustained. If the investor is inclined to seek legal relief, the investor should keep in mind that there are statutes of limitations within which the investor needs to file his or her claim or lose the same. Similarly, if investors are inclined to file legal action, they should be reminded that the law requires that investors mitigate their damages. Stated another way, once the investor discovers that they have been the victim of improper conduct, they have an obligation to act reasonably in an effort to reduce damages. Waiting to see what happens could, in some cases, reduce the extent to which an investor can recover damages.

Advantages to Selling

There are clearly advantages to an investor selling his or her auction rate securities in the secondary market immediately. The primary advantage is, of course, liquidity. By selling in the secondary market, the investor immediately turns all or a portion of his or her auction rate securities into liquid cash.

A second advantage of immediate sales is the complete avoidance of future uncertainties in the marketplace and the economy. By selling in the short term, the investor is no longer subject to adverse market or economic developments that could result in substantial diminution of the value of what he owns. Likewise, the investor no longer needs to be concerned about the private resale market disappearing.

If the investor is contemplating legal action, selling accomplishes several advantages. First, it fixes the investor's damages. Second, if the investor is hiring a lawyer on a contingency basis, the investor will likely end up paying a smaller contingency fee if his claim is successful. Third, the investor will have mitigated his or her damages and will be subject to fewer arguments that part of the investor's loss is his or her own fault.

Selling in the short term also gives the investor some degree of certainty with respect to his investment holdings. The investor may find that peace of mind is beneficial. The investor will no longer worry about the position, worry about whether there will be a future market for the position, worry about whether he or she will have access to cash if needs arise, or worry about the impact of future economic developments on his or her holdings.

Advantages to Waiting

Waiting also can have advantages to an investor. Obviously, the biggest advantage would occur if his or her auction rate securities are redeemed or refinanced, in whole, in the near future. This would give the investor liquidity and would remove the uncertainties attendant to the current frozen market at no loss to the investor.

Waiting would allow the investor to avoid taking an immediate discount (realizing an immediate loss) on his or her auction rate securities holdings. According to recent reports, municipal auction rate securities and auction rate preferred stocks can often be sold for between 85% and 92% of face value. Student loan auction rate securities, on the other hand, often can only be sold at a discount of 25% to 50% of face value, if at all. Thus, investors must anticipate that they will not receive face value if they decide to sell their auction rate securities.

If the auction rate securities are redeemed or refinanced in whole, the investor avoids any inconvenience associated with contemplated legal procedures. No time, effort or expense is necessary.

How to Sell

A private market has developed in illiquid auction rate securities. Restricted Securities Trading Network (a/k/a Restricted Stock Partners) in New York has been coordinating this private market activity over the past four months and has been able to conclude successful dispositions of illiquid auction rate securities in many instances. Restricted Securities has become a respected presence in this illiquid market. Individuals interested in exploring the sale of their illiquid auction rate securities should contact Preston Blankenship at (212) 668-3903. Institutions interested in exploring sales of their illiquid auction rate securities should contact Brendan O'Connor at (212) 668-3909.

Conclusion

In summary, there is no absolute right or wrong course of conduct for an investor to follow. There is much uncertainty in the future. Each investor is encouraged to evaluate his or her own financial circumstances and needs, the securities held, the investor's beliefs about future developments, and the investor's risk tolerance in reaching a final decision.