Hey Dumb ARSe! (Part II)

As a follow up to my post yesterday, this is an update on the situation in the ARS (auction rate securities) market.

Background:

On Thursday of last week, six Goldman ARS auctions failed, which means (GS: 178.41 +1.05%) did not provide a supporting bid to take up the slack for the lack of buyers to meet supply by the sellers. Those six issues that didn’t clear represented about $500 million.

Not surprisingly, a lot of institutional investors started asking questions about the structure of the auction market for the short term 7-day “floaters”. Then last Friday, JPM didn’t support its auction issues. The crack started to widen.

This past Monday, the student loan ARS auctions “failed”. This sector is currently in distress and many auctions are not clearing the available supply. This was followed by news on Tuesday that Citi didn’t clear student loan and muni issues as lead manager. Then yesterday, MER, LEH, UBS, et al, didn’t clear their CEF (closed end fund) issues, which are names like Nuveen, Blackrock, Calamos and Eaton Vance.

In most cases, the holders of these are largely institutional investors. They are paid high “max” rates of interest in many cases to hold the securities until they can sell them at the next weekly auction. [Can anyone say, “money market mutual funds”? and “corporate treasury accounts”?]

Onward. Let me define what the term “ did not clear” means.

This means that there are not enough buyers to match sellers. When this happens, the auction “fails” and the interest rate on the ARS goes to the “max” rate. This ends up being bad economics for the issuer and will likely lead to deals being collapsed (shares redeemed). But eventually, the market will “right size”. More on that later.

Let me digress and briefly explain, in laymans terms, how these instruments are structured.

Let’s say that I’m a fund manager of a CEF that invests in muni bonds. As you well know, a CEF is a mutual fund that is traded on an exchange like a stock, as opposed to an open end fund that issues shares to new investors as it takes in new money.

Since I don’t have sources of new money, other than the current interest on my muni portfolio, my local MER investment banker may then approach me, offering to underwrite an ARS bond issue for my fund. The securities issued are sold at auction where buyers bid an interest rate that they want to earn on their money. In the case of a muni ARS, the interest is tax free. Also the interest rate will reset, in most cases, on a weekly basis, on the same day of the week that they were originally auctioned off. This happens weekly until the securities are redeemed by the issuer (me, in this example). Also, because of the reset, the interest rate is variable. It is tied to an interest rate index, like BMA. Hence the term, “floaters”.

The reason why I would do this? ……. leverage. I can take the proceeds from the offering and go out and by longer term muni paper at a higher interest rate and make the spread between the interest rate I’ll get and the interest rate I’ll have to pay on the muni floaters. This is one way I can juice the the common dividend on the CEF shares.

MER, as the lead underwriter, has a moral obligation (not a contractual one) to provide supporting bids each time the issue comes up for the weekly auction. That means that they are the buyer of last resort. They step in and provide liquidity to the market, which allows for orderly transactions of the muni ARS auctions each week. This has been the protocol for the last 20 years. As we know now, the underwriters are refusing to do this.

Now, when an auction fails to clear, the investors holding the securities are now required to hold some or all of the securities until the next auction, but are paid a penalty rate of interest, the “max rate”. By the way, that interest penalty is to me, the issuer. The maximum reset rates for these deals have been reported in excess of 6% tax free, in some cases.

Yesterday, this situation spilled over from the student loan and taxable issues, to the “muni preferred” market. Again, these deals are sold as leverage to closed end bond funds (Nuveen, Blackrock, et al).

Most of the securities in these deals are held by individual “retail” investors, like mom and pop. These muni preferred auction securities, aka “tax free floaters” don’t normally offer the egregious maximum rates to the investors in taxable issues who experience a postponed auction. While each deal might vary, the max rate on tax free floaters in most cases, is based on 110% of the BMA index, which puts the yield currently at about 3.30%, tax free. (The taxable deals have a max rate that is typically 150% of LIBOR, or about 4.65%, currently.)

Queston #1: If I’m an investor in these things, and I want to get out, can I?

Maybe. Let me give you an example:

Let’s assume that there is $10 million worth of supply (sellers), but only $5 million worth of demand (buyers). We can’t match the buyers with sellers. Now, if the underwriter like MER doesn’t put any support bids to “backstop” the issue, that auction is not going to ”clear”. We go to the max interest rate. However, since there are some buyers, the sellers would be able to get out on a pro rata basis, in this example, 50% of their position could be sold. The other 50% would have to wait for the auction again next week. The transaction is pro rata across all the sellers, not on a FIFO basis. The buyers, obviously, would get 100% of what they wanted to buy.

Question #2: If an auction fails to clear, and there are no buyers, what happens then?

The answer is….we don’t know. The auction could continue to fail week after week.

Fund managers do have the option to de-leverage their fund, and unwind the floaters, but will they do that? Again, we don’t know at this point. However, I’m almost certain there will be some arm twisting to get them to do just that.

In my case, as the hypothetical muni fund manager, I could sell assets in the muni portfolio and redeem the muni floater, thus taking the leverage off the common shares of the fund.

It is called a muni “preferred” because it is senior to the common shares of the fund. Usually, when a muni ARS issue is structured, there is normally 300% coverage by the assets in the fund to the ARS. In addition, the fund always structures the issue so that there will always be, at a minimum, 200% coverage, guaranteed at any time.

If the NAV of the overall fund falls below 200% coverage of the preferred, I would be forced to redeem the preferred to maintain the coverage ratio.

So the reason why an auction ”fails” is not a credit issue, but a liquidity issue and the added concern with the auction process overall.

Again, it is a liquidity issue, not a credit issue. Think about it. You have the coverage (collateral, if you will) of 200% at a minimum; you have the credit rating, usually A or better; and you have the diversification within the muni portfolio.

That all said, expect the situation to continue, if not worsen in the near term.

Eventually, the market will right size through de-leveraging by the fund managers or buyers coming in to seize the opportunities of higher max rates. We just don’t know when this will happen. In the meantime, the current holders of ARS will get a max rate each week, until an auction clears.

The ramifications of all this are better left as the subject of another post. I’m sure you can think of a few “shoes” that could drop as a result of all this.

Be well and have a great and worry-free President’s Day weekend.