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?