CDFA Spotlight: Auction-Rate Securities Market Changes Forcing Issuers to Pursue Alternatives By Stan Provus

Problems with the auction-rate securities market have dominated industry headlines for the last several months. With the erosion of the once commonly used, low-cost bond financing option, issuers have been looking for cost effective alternatives. There were about $325-$369 billion of auction-rate securities (ARS) outstanding, of which nearly half was municipal debt. Once auctions began failing, market participants have been pursuing several options for ARS.

This article examines the current state of ARS and how issuers have dealt with a major change in the market. The Council of Development Finance Agencies previously released on article describing ARS and how the auction process works. Before discussing the current ARS market, readers may want to review the earlier CDFA article.

Background

Auction-rate securities are bonds with variable interest rates. Typically, interest rates are reset through Dutch auctions every seven, 14, 28 or 35 days. Not unlike Variable Rate Demand Obligation (VRDO) bonds, ARS can provide low, short-term interest rates on long-term bonds. In the past, many ARS had 30-year maturities. Auction-rate bonds are sold at par, and the interest rate the issuer pays and bond investors receive is established at each periodic auction. The interest rate is set by an auction in which bids for ARS with successively higher interest rates are accepted until all the ARS at the auction are sold. The interest rate at which all the securities at auction are sold (assuming no failed auction) is called the “clearing rate.” The clearing rate is the interest rate that will apply to all of an issuer’s ARS until the next auction takes place.

Over the past decade, municipal ARS grew substantially for several reasons. The trading difference between ARS and VRDO bonds narrowed significantly. Secondly, there has been some retrenchment by letter of credit banks that provide the liquidity facilities for VRDO bonds. Finally, ARS became cheaper than VRDO bonds for many issuers because the bond insurance credit enhancement cost for ARS was less expensive than letters of credit for VRDO bonds.

Recently, there have been hundreds of “failed” auctions, which occur when a clearing rate is not established at an auction. Meaning, there are not enough bids at sufficient interest rates to cover all the ARS for sale at an auction. When a failed auction occurs, issuers pay an interest rate established in the bond documents that are typically well above market rates. In recent months, some issuers have seen their ARS rates increase from less than three percent to eight percent or more. This, in turn, has driven the desire among issuers to change their ARS to other interest rate modes.

Failed ARS auctions have been largely driven by the problems facing the bond insurers, the credit crunch and a “liquidity” crisis in the credit markets. From the perspective of an ARS bond investor, “liquidity” is the ability to sell their ARS bonds at par at any given auction. In other words, to get their money back fast. When there are failed auctions, those bond buyers who want to sell their ARS cannot, so ARS become illiquid. Unlike the VRDO bonds, there is no letter of credit bank that must step in to buy the ARS bond at each interest reset date, if the remarketing agent cannot sell the ARS bond to someone else. In other words, bondholders of auction-rate securities do not have a legal right to tender their bonds at par in contrast to variable-rate demand obligations, which are municipal bonds that carry tender rights and are usually supported by an external liquidity facility, typically a letter of credit. This makes VRDO bonds very liquid.

The bond insurers and large investment bank broker-dealers have incurred large losses on collateralized debt obligations over the past six months. Losses are expected to continue and could reach well over $50 billion among the bond insurers alone. The market is now discounting the insurance on ARS bonds secured by insurers who are having problems and only looking to the underlying rating of the issuer/conduit borrower. In an interesting dynamic, since most ARS are credit enhanced with bond insurance, even though ARS rates have risen with the failed auctions, bond investors want out. Investors that wanted to sell their ARS, apparently concerned about both liquidity and the prospect of their insured bonds being downgraded, fueled the mismatch between buyers and sellers at ARS auctions. In the past, ARS were sold to investors, mostly corporate or institutional buyers, as liquid investments but this is not the case today.

Finally, there are fewer broker-dealers bidding on ARS at auctions, which have also contributed to the liquidity problem because there are fewer buyers for investors who want to sell their ARS. Meanwhile, there are many more investors who want to sell their ARS. This is because the broker-dealers have their own liquidity problems and, secondly, because there are now stricter SEC rules governing broker-dealer bids at auctions. These transparency rules were adopted in May of 2006. They included an SEC order issued to 19 broker-dealers to cease and desist from engaging in a number of practices that violated securities laws which included bidding to prevent failed auctions without adequate disclosure.

How Issuers/Conduit Borrowers are Refinancing ARS

As issuer/conduit borrowers began to examine ways to restructure their ARS to other interest rate modes, concerns arose over the SEC’s May 2006 order. Under this order, it was not clear to many bond counsels whether or not issuers/conduit borrowers could bid on their own ARS at auction without violating SEC market manipulation and other securities laws. On March 14, 2008, the SEC determined in their “no action letter” that issuers could bid on their own ARS to avoid a failed auction. In late March, the Treasury Department issued a similar notice.

Issuers have pursued several strategies to refinance their ARS to other interest rate modes such as VRDO, put bonds (long-term fixed rate bonds with 2-5 year puts) and plain fixed-rate bonds. These include the following:

1. Conversions: Almost all bond documents authorizing the issuance of auction-rate securities provide a mechanism to convert the interest rate mode from an auction-rate to another mode, with such conversion taking place upon a mandatory tender. However, conversion may not always be the most prudent approach. A conversion will depend upon a successful remarketing which will depend upon a number of factors including existing market conditions and the underlying credit of the obligor. An unsuccessful conversion could have adverse consequences and the bonds could remain in the auction rate and go to the maximum rate.

2. Conversions followed by Refundings: Kate Tompkins, a bond counsel at Squire, Sanders & Dempsey LLP in Cleveland, explained that some conduit borrowers are utilizing the conversion process as an interim step. These borrowers are using existing lines of credit or other forms of liquidity to purchase the bonds for their own accounts on the mandatory tender date and then instructing the remarketing agent not to remarket the bonds. The conduit borrower then holds the bonds, which are not redeemed or extinguished, until it is ready to refund the issue. Issuers may also be in a position to avail themselves of this option, but an issuer’s ability to purchase and hold the bonds is more limited, and before seeking to convert, an issuer should consult with its bond counsel to make sure such actions do not adversely affect the tax-exempt status of the bonds.

3. Suspensions: Steve Chilton, Senior Vice President at MassDevelopment, says some of the eleven ARS issuers MassDevelopment is working with had looked into suspensions but found them to be unworkable or too difficult to get agreement among an existing bond insurer and new LOC bank. With suspensions, an issuer would suspend the bond insurance for a couple of years and replace it with a letter of credit. The LOC would secure VRDO bonds during the suspension period. The premise with this strategy is that in a few years the ARS market would return to more normal levels.

4. Other Options: On March 27, Moody’s hosted a Webcast, Changing Dynamics of a Market in Flux: What are the Implications for Municipal Credit?, that advanced several other ideas to help issuers restructure their outstanding ARS. A long-term solution was depositing ARS into a custodial agreement, while credit enhancing the custodial receipts with a letter of credit. Meanwhile, under this approach, the custodian would hold the bonds and fix the rate an issuer would pay. Depositing ARS into a trust for a set period of time was offered as a possible short-term solution. This strategy would fix the issuer’s interest rate for a set period of time such as 9-12 months, while giving the issuer more time to plan a refunding or other refinancing. Adding optional tenders to ARS was another idea, which would give bondholders the right to “put” bonds if a failed auction occurs. The put would need to be supported by a letter of credit or standby bond purchase agreement.

A number of issuers are using current refundings, conversions and other strategies to convert their ARS to VRDO bonds. There has been a substantial increase in the letter of credit business as issuers with ARS outstanding scramble to get rated letters of credit from banks to support VRDO bonds. Letter of credit fees have risen because the LOC banks still have a limited capacity to provide LOC and some issuers may be unable to get them at all.

Issuers that have elected to restructure ARS as VRDO bonds are still doing interest rate swaps, swapping variable VRDO rates to a fixed rate, despite some recent compression between the SIFMA VRDO index and one month Libor. When these rates get closer to each other, issuers will pay more in swap deals, assuming their counterparts are paying a percentage of Libor such as 68 percent. Nevertheless, swaps may still be an effective way to access historically low fixed rates.

In addition, GE Government Finance’s Dave Markovchick, Regional Vice President for Business Development in New England indicated his group has been working nationwide with ARS borrowers on either conversions or refundings in the form of private placement purchases.

” The private placement vehicle provides borrowers the opportunity to exit the public markets at considerably lower cost of re-issuance or conversion with a rate that is fixed for the full term or adjusted on a short term basis,” Markovchick said. “In effect, this brings the bond rates more in line with the historical all in cost of public offerings without the complexity and cost of a public offering and without the uncertainty that is anticipated to follow other public market structures as they continue to evolve.”

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.