ARS Auction Failure

ARS or Half-ARS-ed? The Credit Crisis Spreads to the Muni Market

IN PURELY FINANCIAL TERMS, the credit crisis now is taking a greater toll than 9/11.

The Port Authority of New York and New Jersey had to pay the unheard-of interest rate of 20% on its auction-rate securities when the auction "failed," that is, did not attract sufficient bidders.

"Even when the Twin Towers fell, the Port Authority [securities] didn't lose money" comments Theresa Havell, who heads Havell Capital Management, which specializes in managing municipal-bond investments. The Port Authority owns the World Trade Center site, which it leased to Silverstein Properties.

Yet, owing to the widening whirlpool that threatens the viability of the monoline bond insurers, the auction-rate securities market has all but ceased to function. Oblivious to this latest deepening of the crisis, the equity market continued to rally, with the Dow Jones Industrial Average Wednesday tacking on another 178 points, or 1.5%, to 12,552,24.

But in the auction-rate securities market, Bank of America estimates 80% of auctions failed Wednesday. That market totals $331 billion, with the largest share--$146 billion in tax-exempt municipal debt, according to B of A.

The failure of the auction-rate securities to draw bids is Round 2 of the credit crisis hitting the money market, the first being the collapse last summer of the market for asset-backed commercial paper. ABCP was used to finance the infamous structured investment vehicles, or SIVs, into which collateralized debt obligations, or CDOs, were stashed. At the bottom of much of that alphabet soup was, surprise, subprime mortgages.

Round 2, however, has less to do with credit risk than liquidity risk because the underlying credits insured by bond insurers such as MBIA and Ambac were sound in the first place. The main function of bond insurance, says Havell, was to bring homogeneity to the muni market where there are "a million CUSIPs," that is, discrete bonds with myriad issuers and terms.

That was especially the case for tax-exempt money-market funds, which needed triple-A short-term paper, says Jim Lynch, a muni market veteran who heads the Lynch Municipal Bond Advisory. That paper is in chronically short supply because states and other authorities prefer to issue longer-term securities to fund long-term projects.

So, Wall Street conjured up long-term obligations that would have the characteristics of short-term paper, in terms of having no interest-rate risk. As for credit risk, that was taken care of by insurance from the monolines, such as MBIA or Ambac. The funds "didn't care if it was the Port Authority of New York and New Jersey or the Port Authority of Guantanamo," Havell quips, so long as it met their rating and other criteria for money-market funds.

Auction-rate securities were an offshoot, but they don't meet the funds' requirements (as set forth in the SEC's rule 2a-7, which governs money-market funds), because of precisely the situation that's arisen. These ARS really are long-term securities, even though the auctions always gave investors a way to redeem every seven or 28 or how ever often they took place.

But if the auction fails, you're stuck. And in the current environment, nobody wants to take that risk, observes Ken Woods, head of Asset Preservation Advisors, an Atlanta municipal asset manager. Even at a yield of 20%, portfolio managers don't want to risk what they thought was a short-term cash equivalent morphing into a longer-term security.

Indeed, adds Lynch, many corporations parked their cash in auction-rate securities to get a slightly higher yield. Now, their auditors may question whether this really is a short-term investment. Discretion is the better part of valor, especially these days, so corporates would tend to want to get out of their ARS.

On the other side, Wall Street broker-dealers haven't stepped into the breach when other bidders for ARS failed to appear. While under no obligation to do so, underwriters of ARS -- Goldman Sachs, in the case of the Port of Authority of NY and NJ -- had been expected to buy ARS when there weren't any others. "We service what we sell" may be fine for your car dealer, but apparently not on Wall Street.

The dealers no doubt see the same list of muni ARS coming up for bid as Havell does, which shows dozens of issues that have maximum reset rates of 15%, tax-free. And anybody willing to bid at the maximum yield probably will get securities, based on the vibes she's getting from the Street.

For more than two decades, ARS auctions almost never failed. Indeed, when an auction of variable-rate preferred bank stock failed in the early 1990s, that marked the nadir of that crisis.

This one feels like it has a ways to run.

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