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Home > Cases > Auction-Rate Securities > Auction-Rate Bond Failures Create Exodus of Borrowers

Auction-Rate Bond Failures Create Exodus of Borrowers

The collapse of the auction-rate bond market has left municipal borrowers everywhere scrambling to take cover. By May 1, at least $21 billion of bonds are expected to be pulled out of the auction-rate market by municipal borrowers, according to a March 21 article by Jeremy Cooke on Bloomberg.com.

The amount is more than what was sold in any one year prior to 2002.

During the week of March 17, nearly 70 percent of the periodic auctions in the $330 billion market failed, as investment banks stopped buying the securities investors didn't want. As a result, interest rates — which are determined through a bidding process managed by banks typically every seven, 28 or 35 days — rose as high as 14 percent.

Yields on municipal bond debt averaged 6.4 percent as of March 12, almost twice what it was on average through January of this year.

The use of auction bonds by states, cities and other municipal borrowers dramatically increased six years ago, with sales doubling from $12 billion to $25 billion in 2002. The market peaked two year later, in 2004, at $42 billion before settling at $39 billion in 2007.

The $21 billion total represents auction bonds that will be called, or bought back, on dates from February through the first day of May, according to data compiled by Bloomberg from an original list of $211 billion of the debt.

Auction Failures On The Rise

In recent months, it's been reported that 60 percent or more of public auctions have failed. From the market's creation in 1984 through 2007, there were less than 50 recorded failures. In the past, brokers would use their own funds to keep auctions from failing. In the aftermath of the subprime meltdown, however, this is no longer the case.

When an auction does fail, the interest rates borrowers must continue paying revert to a set level of 10 percent or more, which is outlined in official statements issued at the initial bond sale. As a result, municipalities from Wisconsin to California are getting out of the market, selling their fixed-rate bonds to replace failing auction bonds.

Among those that have gone this route:

  • The Port Authority of New York and New Jersey sold $700 million of bonds in March to refinance auction securities after rates on its debt soared from 4.3 percent to 20 percent.
  • The state of Wisconsin sold nearly $800 million of bonds to replace auction debt that rose in cost to as much as 14 percent.
  • Philadelphia is expected to sell fixed-rate bonds in April to replace auction bonds that have been failing. Rates on almost $100 million of Philadelphia's 2003 debt rose to 5.35 percent from 3.75 percent in October.

The ongoing string of auction-rate bond failures serves as a cautionary tale on the dangers of even the most calculated of risks. Back in 1984, auction-rate securities backed by municipal bonds were perceived to be safe and secure. Times have changed — dramatically. The subprime meltdown has triggered the unprecedented, with a prolonged period of market instability that is creating costly failures everywhere.

Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage related investment losses.


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