Municipal Auction-Rate Market A Shadow Of Former Self
The auction-rate securities market has dwindled to about half  of what it once was just four short months ago, after municipal borrowers moved another $3 billion of auction-rate debt late last week.
To date, states, local governments, hospitals and colleges have converted, refinanced or plan to redeem at least $81.3 billion of the $166 billion in municipal securities, according to a June 16 report by Jeremy Cooke on Bloomberg.com.
The mass exodus of borrowers from the auction-rate securities market began in earnest this February, following a lack of product demand and a move by Wall Street investment banks - which previously conducted the auctions for the securities - to pull back their financial support when there weren’t enough bidders.
As reported in the Bloomberg.com article, about 48 percent of municipal auctions are failing daily. Preferred shares of closed-end mutual funds and debt backed by student loans, which made up a significant portion of the $330 billion of auction-rate securities outstanding earlier this year, have fared far worse. Their failure rates currently stand at about 99 percent.
Until this year, failed auctions were few and far between. From 1984 through 2006, 13 auction failures have been recorded. When auction securities were first sold in 1984 for American Express Co., investment banks such as Merrill Lynch, Citigroup and UBS were on board with their own capital to prevent an auction from failing.
Beginning in February 2008, however, it became a new ballgame. With their balance sheets financially drained from taking on millions of dollars in subprime mortgage-related write downs and credit losses, the banks abruptly stopped their role as a buyer of the last resort in the auction-rate market.
Subsequently, auction after auction began to fail, and the auction-rate securities market became yet another casualty of the nation’s ongoing subprime problems. In the aftermath of the auction market’s collapse, investors had to come to terms with the reality of being stuck with what they thought was a short-term, cash-equivalent investment, while issuers of auction securities faced exorbitant penalty interest rates, sometimes as high as in the double digits.
And even though the average interest rates at weekly municipal auctions currently are in the 3.17 percent range - well below a recent record high of 6.89 percent - a growing number of issuers of auction-rate debt are getting out of the market entirely, believing auction securities are no longer a viable investment product.
In other auction-rate securities news, the U.S. Securities and Exchange Commission (SEC) apparently has cleared the way for Eaton Vance, the third-biggest U.S. closed-end fund manager, to issue “liquidity-protected preferred shares†to institutional investors and money-market funds. The new form of preferred shares, which includes a right to sell option for investors, is intended to provide some relief - though how much is unknown - to investors by helping finance the repurchase of frozen auction-rate securities, according to the company.
Similar plans have been touted by BlackRock Inc. and Nuveen Investments. The timing of when these plans will go into effect has yet to be determined.
Moving forward, however, the future of the auction-rate securities market still remains in limbo. While the municipal auction-rate market may have regained some liquidity in recent weeks, other auctions continue to be frozen. Investors who own any of the $85 billion of auction debt backed by student loans know this only too well. On the secondary market, student-loan-backed debt is trading for as little as 75 cents on the dollar. For these investors - who were marketed auction securities as a high yield alternative to money market mutual funds and who are now facing massive financial losses - the long-term view of the auction market is not a good one. .
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