From the June 2008 issue of Investment Advisor • Subscribe!

The Continuing Crisis in Auction Rate Securities

While news of trouble at monoline insurers seems to have slowed since February, the municipal bond sector still faces critical challenges. At risk in particular is the market for so-called auction rate securities (ARS), which municipalities use to issue tax-exempt debt at a lower cost. Many experts agree that the troubled ARS market is more the result of a liquidity crisis--with banks pulling out of the auctions--than a credit issue, despite the fact that monolines have helped depress valuations for some time.

ARS are long-term bonds that reset periodically, usually every 35 days. The funding mechanism helps issuers lower their costs because the issuers of those bonds earn long-term yields on the asset side of the balance sheet while paying short-term rates that are reset periodically by the market. Banks conduct auctions to facilitate the determination of the short-term rate.

The risk for ARS municipal issuers arises when the rates reset by the market turn out to be higher than what public contracts stipulate under a predefined "cap rate" provision. Since the reset rate is determined by market bids, there is always the possibility that an auction could go wrong if the market turns skittish, propelling yields to higher-than-desirable levels. This didn't really happen until February. "Since February, this market has imploded because banks pulled out of the auctions," says George Friedlander, municipal strategist at Citigroup, Inc. This lack of bids led the market to dry up. Yields reached unacceptable levels for public issuers.

"We're still in scary times in the municipal bond market," says Friedlander. "Muni yields went significantly higher than their taxable equivalent, which makes absolutely no sense to me or to anyone [else] in the market." Municipal yields almost by definition are lower than their taxable counterparts because muni debt offers investors tax exemption on the earned coupons.

Banks the Culprits?

The ARS crisis is far from over, but the blame for causing the turmoil has shifted from monolines to banks. The monoline crisis seems to have reached a more stable level thanks to recent capital infusions into bond insurance companies. This simple recapitalization process has provided more stability to those firms' ratings.

Many now consider that the municipal market woes are a direct result of liquidity drying up and say that is has little to do with ratings, insurance, or credit fundamentals. Indeed, a persistent lack of liquidity and the resulting deterioration of banks' balance sheets will likely make matters worse.

"If liquidity backdrops were available and cheap, many of these problems would be solved quickly but they're not," says Friedlander, who goes on to point out that, "since the end of February, banks have been bringing restructuring auctions rather than bringing new issues."

The outcome of this crisis appears gloomy, to say the least. Many experts do not see the ARS market recovering any time soon. "There will be more headlines, taxpayers' revolts, large budget gaps, and belt tightening. This is going to be a more volatile period than anything we've seen since the 1970s," laments Friedlander. "The market has been wounded. It will heal itself with scar tissue in the flesh."

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