Holders of Student-Loan-Backed Auction Debt Face Grim Future
Investors in auction-rate securities have quickly discovered that all things are not created equal. While the dark clouds surrounding auction rate securities are slowing lifting for investors in auction-rate securities sold by municipalities or closed-end mutual funds, investors who own any of the $85 billion of auction debt backed by student loans continue to face a perpetually stormy forecast.As reported in the May 28 issue of Business Week, student-loan-backed auction-rate bonds have ended up as one of the worst-performing areas of the auction bond market. Trading for as little as 75 cents on the dollar in limited secondary market trading, investors in these securities have taken huge losses on what they thought were low-risk, cash-equivalent investments.
The main problem facing investors who hold student-loan-backed debt is that the government-run and private student loan lenders responsible for issuing the securities do not have the ability to generate additional financing to redeem their bonds at par. Moreover, the penalty rates on many of the student-loan-backed auction bonds have temporarily fallen to 0% and by law, the trusts that issue student-loan-backed bonds cannot pay out more than they receive as interest payments from borrowers.
How It Began
Auction-rate securities - which are long-term bonds sold by issuers such as municipalities, student loan companies, hospitals and closed-end funds - have interest rates that reset every seven, 14, 28 or 35 days. For decades, the auction-rate market operated relatively smoothly, with only 13 auction failures reported between 1984 through 2006.
In February 2008, however, everything changed. The credit ratings for the bond agencies responsible for backing the auction bonds were unexpectedly downgraded. In turn, new investors were no longer willing to bid in the auctions, leaving existing investors holding securities for which there were no buyers. The Wall Street investment banks, which once prevented the auctions from failing by stepping in with their own capital to buy the bonds, pulled back their support entirely.
Following the collapse of the auction-rate market, a number of “rescue plans†were put in motion. Some municipalities began redeeming or announcing plans to redeem more than $60 billion of the $165 billion of auction-rate bonds they issued. Closed-end fund issuers also began making some headway, redeeming about 23 percent of the auction-rate preferred stock shares they have backed.
As for student loan issuers - and the investors holding the student-loan-backed debt - the picture remains grim. Thus far, only the Missouri Higher Education Loan Authority (MHELA) has announced a rescue plan, according to the Business Week article. Reportedly, MHELA has plans to buy back approximately $30 million of its $3.5 billion of outstanding debt at a discount.
Meanwhile, investors who hold student-loan-backed debt can only sit and wait. To date, almost all of the auctions in the student-loan auction rate market continue to fail and only $1 billion of the $85 billion outstanding has been refinanced. For now anyway, it appears these investors are permanently sucked into the auction-rate vortex - and have little chance of getting out.
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