Auction Rate Securities: What Now?

The Background
Auction Rate Securities (ARS) are typically either a debt instrument with a long-term maturity or preferred stock in which the interest rate is determined through an auction process. These rates normally are reset either weekly or monthly through periodic auctions. The ARS market reached about $350 billion at its zenith. About half of this market was for tax exempt securities. The issuers of tax-free ARS are municipalities, closed-end muni funds, and corporations that qualify under the “public purpose” provisions of the tax code. The ARS market was designed to act as a low cost funding mechanism for these issuers. Since early this year this market has been in disarray due to liquidity disruptions. Many investors have had their funds frozen because of a rash of failed auctions. At one point, over 80% of all auctions failed. When an auction fails the investor receives the penalty rate which is disclosed in the initial offering papers for the security. This penalty rate varies widely from a very low rate up to 20% depending upon the terms outlined in the offering documents of each issue. These securities normally come in $25,000 denominations.

Who Was At Fault?
Bankers and other Public Finance types get paid by generating revenues. The ARS market, just like Sub-Prime structured products, grew out of this need by Investment Bankers to generate out-sized year-end bonuses. The ARS market needed a “hook” to be successful. The “hook” for the issuer was cost savings from the ability to avoid paying for another bank to provide liquidity for their money market securities. The “hook” for the investor was that they would receive better than money market rates for taking virtually no risk of a failed auction, because their broker’s firm always made sure the auctions were successful. These securities were appealing to ignorant and greedy brokers who were now able to get bigger commissions on “money market” alternatives. For awhile this strategy worked and the Bankers were able to create a $350 billion market that was a fee generating machine. Unfortunately, early this year investors and issuers both discovered that the Emperor had no clothes. When auctions failed, issuers found that their costs were much higher than the Bankers had promised, and the investors lost access to their funds despite being told “they were as good as money markets, no they were even better than money market funds”.


How TFS Avoided The ARS Debacle?
Virtually all credit crises were caused by investors underestimating the amount of risk they were taking. The ARS market meltdown is no exception. Our perception of risk helped us to avoid ARS. We chose to invest in Variable Rate Demand Notes (VRDN) instead of ARS, because we knew we were not getting paid to take the additional risk of a failed auction. The chart below shows that prior to the ARS meltdown we actually received on average about an extra .04% yield by purchasing VRDN’s instead of ARS. These instruments are money market eligible and trade in $100,000 denominations. They are issued by many of the same issuers that also issue ARS. It is common knowledge that ARS are not money market eligible, because the investor does not have their liquidity guaranteed when he/she desires to liquidate their securities. Institutional investors know that a VRDN is money market eligible, because there is a liquidity facility guaranteed by a Standy Purchase Agreement. We reasoned, “why would anyone buy an ARS at a lower yield when it is an inherently riskier investment?” The only explanation for this enigma is that investors were unaware of the liquidity risk in these securities, and they let their brokers spin them around by selling them something with more risk than they thought they were taking. This situation clearly shows the conflict of interest that may exist between a broker/salesman and the investor.

Prospects For The Future
The ARS market has rapidly shrunk to half its former size. The cost savings the Bankers promised have turned into additional expenses instead. So, issuers have called outstanding issues of ARS with high penalty rates and replaced them with VRDN’s, put bonds, or long-term bond issues. This trend will likely continue for the next 6 months until most investors’ ARS funds have been freed up, and issuers have escaped the fiasco known as the Auction Rate Securities market.