Richard Ellis

I remember last summer when the first concerns about the sub-prime mortgage market were raised. The public was reassured that the damage was “contained” and wouldn’t ripple through to other segments of the capital markets. How wrong that has proven to be.

Now, nearly a year later, issuers of taxable and tax-exempt debt are scrambling to refinance variable rate bonds issued as Auction Rate Securities (ARS). For 20 years issuers have issued long-term debt at short-term rates using ARS. In other words, the bonds might mature in 20 years, but the interest rate paid was based on a 7, 28 or 35 day auction rate. On the remarketing date, the bonds would go through an auction process to establish a new interest rate.

One advantage to this type of variable rate debt is the lack of the need for a liquidity facility. The bonds were issued with bond insurance which guaranteed the payment of principal and interest in the event of default. This saved 15 or 20 basis points (1 basis point = 1/100 of a percent) in fees, which means a lot when the remarketing rates are in the 2 to 3 percent range.

Since February 12, the vast majority of auctions have failed, meaning there was not enough demand from buyers to match the supply from sellers. The result is the seller is stuck with a bond that they don’t want.

So how did we get to this point? The bond insurers expanded their business to insure structured investments that included sub-prime mortgages. As these investments have started to fail, the capital of the bond insurers is consumed covering these losses. This led to the bond rating agencies downgrading the bond insurers because they no longer had sufficient capital to cover their liabilities.

With the bond insurer having a lower rating, investors can no longer legally purchase, or may refuse to purchase, the ARS. The investment banks that remarket the ARS, which have traditionally made a market for ARS securities, have their own capital problems as they are forced to write down billions of dollars of losses. With no one buying, the securities have no liquidity and the seller is left holding the unwanted bond.

This is an over simplification, but reflects the realities of the market. The ARS market, which has thrived for over 20 years, appears to be headed to complete collapse. Ironically, many of the credits backing the ARS securities are very strong, but the buyers are gone. As a result, the municipal bond market is flooded with refinancing or conversions of ARS into fixed rate bonds or other types of variable rate bonds that are more expensive.