Auction-Rate Market Shrinks By $51 Billion
Facing higher interest costs from failed auctions, municipal borrowers are taking flight from auction-rate securities and beginning the long process of refinancing their auction-rate debt.
As reported in an April 11 article on Bloomberg.com, the $330 billion auction-rate market is shrinking by at least 15 percent, or $51 billion. To date, states, cities, hospitals and higher education institutions have converted - or are planning to replace - at least $43.1 billion of the debt.
In addition, several issuers, including Nuveen Investments Inc. and seven other fund managers, say they will redeem $7.8 billion in taxable preferred shares that have rates set through periodic dealer-run auctions.
According to data from Bloomberg.com, year-to-date municipal bond returns gained 1.17 percent, after falling 0.82 percent in the first three months of 2008.
The Bond Buyer 20-Bond Index, a weekly gauge of long-term municipal yields, fell 29 basis points - which is the most in at least 18 years - to 4.61 percent on April 10. That is the lowest since the week of the auction market's collapse.
Finally, an index of rates on debt with auctions held every seven days fell 1.05 percentage points to 5.67 percent on April 2, an eight-week low.
Still, while the rate has fallen from a record 6.89 percent two months ago, it remains 2 percentage points more the average in 2007. The high yields, combined with routine failures on almost three-quarters of all auction debt put up for bid, have been enough to cause borrowers to jump ship from the auction rate market.
Auction Failures
Until now, in fact, the auction-rate securities market has worked relatively smoothly for more than two decades. Then, in February 2008, the subprime virus began to spread to other segments of the financial world. Brokerage firms, which once supported the bond auctions, pulled back their financing and thereby allowed auctions to fail. As of April 10, more than 70 percent of weekly or monthly auctions were unsuccessful.
As for investors in auction-rate securities, they have been left stranded - holding investments without a market.
When an auction fails, interest rates reset to a level previously determined when the securities are first issued. As a result, some sellers can be looking at new interest rates in the double digits.
Broward County, Florida, for instance, saw its interest rate on recent auctions rise to 10 percent and 6.37 percent, from 4.75 percent and 5.25 percent in January. Currently, Broward is preparing a fixed-rate sale for late May to replace about $101 million of auction-rate debt.
In early March, Nuveen Investments, the largest U.S. manager of closed-end mutual funds, announced plans to find alternate financing to bail out investors from $4.3 billion of auction-rate shares that had been sold by 13 taxable funds to boost returns.
Regardless, it stills leaves as much as $11.1 billion of preferred shareholders in frozen tax-exempt securities that were sold by funds investing in fixed-rate state and local debt, according to Bloomberg.
The most intriguing aspect regarding the rise and fall of the auction-rate securities market continues to be Wall Street's role in it. Consider the fact that it's the investment firms responsible for conducting the auctions. For that role, the firms receive a substantial amount of money. These same firms also take in a fee based on the amount of money raised in an auction. If an auction fails, the firms still receive this fee.
The question then becomes this: Does it really matter to Wall Street if the auction-rate securities market thrives again or wilts on the vine? Either way, Wall Street wins.
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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