Auction-Rate Securities: Where Do We Go Next?
Concerned by the auction-rate bond market's apparent descent into collapse, state officials are now taking measures to find out exactly why auctions have failed and how interest costs could soar as high as 20 percent for some borrowers.
An article on Bloomberg.com by Michael B. Marois and Michael McDonald highlights the ramifications of the failed auctions, which show no signs of letting up. Since February, more than 60 percent of the auctions that are sold by cities, colleges, student lenders and closed-end funds have failed because of no interest from investors.
As a result, rates on bonds auctioned weekly averaged 6.72 percent as of March 26, up from 3.63 percent in January, according to the Bloomberg.com article.
Massachusetts Secretary of State William Galvin is now focusing his attention on the failed auctions, issuing subpoenas on March 28 to three investment firms for information on how they marketed auction-rate securities to investors. The firms included in his probe are: UBS AG, Merrill Lynch and Bank of America.
Interestingly, on the same day Galvin's office subpoenaed the three firms, UBS announced that it would begin cutting the value of auction debt held by its customers.
In a press release, the Massachusetts Secretary of State said his office initiated the investigation following numerous calls from investors, “who thought they were investing in safe, liquid investments only to find that they had, in fact, purchased auction-market securities that are now frozen and they cannot get their money out.”
Problems for Municipalities, Small Investors
With much of the auction-rate securities market now frozen, thousands of individual investors are left with their funds locked up in illiquid investments. For issuers of the bonds, such as municipalities and nonprofits, they are left facing stiff penalties in higher interest rates when the auctions fail.
For many municipal borrowers and nonprofits, this leaves no alternative but to exit the auction market entirely, and convert auction debt to fixed-rate bonds. According to the Bloomberg.com article, issuers have converted $20 billion to $30 billion of auction debt to avoid interest penalties.
The city of Vernon, California, for example, has lost $7 million since mid-February on the auction-rate bonds it sold to reduce borrowing costs for power plants and natural gas contracts. Interest on some of the $482 million issued by the city climbed to as high as 18 percent since Feb. 15 from a low of 4.5 percent.
Others are looking at similar fates. According to the Bloomberg.com article, Stanford University in Palo Alto, California, replaced $188 million in auction debt in early March, selling taxable commercial paper, or debt due in nine months or less. Rates on the two series of tax-exempt bonds reached 8 percent last month, from about 3 percent in January. Stanford has an additional $133 million in auction debt outstanding that it plans to replace, as well.
San Bernardino County in Southern California is another example. It plans to sell $160 million of taxable pension obligation debt with fixed rates to replace auction debt. Rates on some of the bonds soared to 14.9 percent on March 26, from 3.7 percent on Feb. 11.
If and when the current auction-rate freeze will begin to thaw any time soon is debatable. Some analysts predict the market's demise. Others contend liquidity will return in the future. For now at least, investors and municipalities alike probably look at auction-rate securities as a nightmare from which no one can wake up.
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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