Failure in Auction Rate Security Market and What It Means

I found this article in today's New York Times to be very reassuring:

http://www.nytimes.com/2008/02/15/business/15muni.html?_r=1&ref=business&oref=slogin

For the time being, I am enjoying getting 10% returns on a credit backed by the Port Authority of NY / NJ, but I am fortunate that I don't need to be liquid immediately.

I was also reassured after reading this article. I have been in ARS for the past year and the liquidity was secondary to the (although I'm not sure by whom). While I wait it out for the liquidity to return to the auction market or the issurer to call the notes, I'm preparing to enjoy 14%. I can live with that.

It is putting pressure on long-term yields though. After all, many insitutional investors did them as a liquid investment and the market will demand more rate as this short-term instruments become long-term holdings.

From what I have read, if you own a bond from an actual municipal issuer you will be in better shape. The rate will go to the max which is usually 10%+ and eventually the bond will be bought by a hedge fund or called by the municipality. If your bond isn't highly rated though, even that could be in jeapordy. The real pain will be felt by ARS issues by closed-end funds. Close-end funds issues ARS to raise cheap cash which they invested in longer-term bonds. The problem is that the default rate on these bonds is pretty low - now around 3.5% and will drop further if the Fed continues to cut. As a result, the value of the overall bond will fall and the fund has no reason to cash out investors.

Here's a good article on the topic:

http://globaleconomicanalysis.blogspot.com/2008/02/its-too-late-to-protect-your-ars.html

I was able to get out of the Port Authority ARS that I own yesterday. I noticed that the reset rate fell from 10% to about 5.25%. That seems to suggest that some liquidity is returning to the market. I expect in to settle down and be completely normal in about 3 weeks.

I was able to get out two municipal ARS but am still locked into a closed end fund - Pimco. It's looking bleak for getting that cash out. The reset rate is pathetic so I imagine the fund is just going to ride my cash. As interest rates drop it's only going to get worse. 2/3 ain't bad I tell myself.

The article that Sam posted is right on. These things aren't all created equal. Those backed by municipalities have reset provisions where in a failed auction the rates spiked higher forcing the municipality to refinance or leading some bidders to return in the next auction (eg. Port Authority gave NY and NJ residents 10% tax free for a week before the rate fell to 5.50%). Those backed by closed end funds (Pimco, Nuveen, Kane Anderson, etc.) have some serious BS reset provisions where these things are basically converted into some form of preferred stock in a failed auction - ie., the rate stays tied to indicies and there is no incentive for other bidders or for the issuer to refinance because it is free money. The holders of those back by closed-end funds could be really screwed.

It is just staggering to me that we are now 5 weeks into this and the MLPs just continue to say the hell with everyone and we will keep them locked up and rely on the default provisions. It just sickens me to see Bill Gross and the Pimco guys on TV bragging that they are getting 12% return on government-backed mortgage securities - and at the same time they have made ARS investors illiquid and are borrowing from them at 4%. The ARS environment may normalize at some point and when it does these may be an important cash equivalent instrument, but the MLP issuers should be avoided forever.

It looks like after months of no resolution, all of the big banks are going to pay out their clients. Merrill, Citi, UBS, and Nuveen have all said they are going to take the hit and allow their ARS holders to withdraw the funds. No doubt impending lawsuits from State Attorney Generals as well as bad press have forced their hand. This will mean billions in new losses for these banks.