Mysterious Auction Rate Securities

By NAR Senior Economist Jed Smith 

Mortgage rates rose in the latest week to a 6.04 percent average, according to Freddie Mac, from 5.72 percent a week earlier despite the very low yield on 10-year Treasury note. That is a mystery and may be a result of a credit freeze of an obscure Auction Rate Securities (ARS).

Issues of financial risk and liquidity are very much in the news. This section focuses on one of the lesser known financial products — Auction Rate Securities (ARS) — with a brief examination of associated risks.

What are Auction Rate Securities?

ARS are municipal and corporate bonds and preferred stocks with interest rates that are periodically reset through auctions every 7 to 35 days. The securities are sold as long term bonds but are effectively turned into short term securities through the interest rate reset feature. ARS are usually issued with intermediate to long-term maturities, but the interest rate re-set feature results in their being priced and traded as short-term instruments. When an auction fails, the issuer is obligated to pay a relatively high interest rate until an auction is successful. Alternatively, the issuer could refinance the security with a different type of financial instrument, typically at a higher interest rate than had previously been the case. ARS have typically been considered to be of high-grade credit quality, are insured, and are callable at par on the auction date at the option of the insurer

• From the issuer's perspective, ARS are an alternative to other variable rate financing vehicles.
• From an investor's perspective, ARS have generally been viewed as an alternative to money market funds.

ARS were first developed in 1984, and the market value is currently estimated at $360 billion. For a specific bond issue the auction is typically managed by broker-dealers, who submit auction orders to the Auction Agent, typically a commercial bank. The Auction Agent collects the orders from the participating broker-dealers, organizes the bids to determine the winning bid, and allocates the ARS based on orders submitted. All bids accept the same interest rate or dividend yields-the clearing rate.

If the Auction Agent does not receive sufficient orders to purchase all the ARS being sold in the auction, the auction is said to have failed, and the rate on the ARS is set at the maximum rate specified in the documents underlying the specific securities. The security holder receives a higher rate of interest, but the sale of the security is temporarily impossible. Traditionally this has not been a problem, for the investment bank(s) associated with the security issue have provided market liquidity. It has been noted that bidding by dealers is essential to the smooth functioning of auction securities. However, some institutional investors have been less active in ARS auctions due to their own financial problems associated with asset markdowns and the need to sell other assets in order to increase liquidity.

There is also concern about the lack of available effective insurance for ARS bonds, given the perception that bond insurers are in a financial crunch. A rating downgrade of bond insurers could compel banks to write-down at least a portion of the value of their mortgage backed securities on concerns that insurers would not be fully able to pay the insurance claims.

Auction Rate Securities-Current Issues

If the Auction Agent receives more Sell Orders than Hold and Buy Orders, the Auction is said to be a Failed Auction, and the Auction Procedures generally provide that the coupon is set at the Maximum Rate, typically a multiple of a reference rate, such as LIBOR, or a fixed percentage, such as 15 percent. A failed auction does not mean the securities go into default, because the issuer continues to pay interest at the higher rate or "fail rate". However, the securities are at least temporarily illiquid.

In mid February a number of ARS auctions failed, resulting in the ARS market becoming less liquid, and issuers needing to pay higher rates to investors. On February 12 it is reported that 202 of 276 auctions failed; a reported 231 of 288 auctions failed on February 15. Examples of failed auctions include the Port Authority of New York (rate reset from 4.3 percent to 20 percent on $100 million of ARS), the NYS Dormitory Authority (rate reset to 6.26 percent from 3.12 percent), and Presbyterian Healthcare of Albuquerque ($38.7 million debt with an interest rate rising to 12 percent). Issuers have to pay much higher interest rates when auctions fail or convert the bonds to fixed-rate alternatives. The key point is that high quality borrowers are paying substantially increased rates.

Information on Rates

The Securities Industry and Financial Markets Association has made available a series of market indices for Auction Rate Securities for both debt and preferred securities. The SIFMA ARS Indices are based on data from actual ARS issues provided by broker dealers and auction agents. The number of issues used to calculate the Indices may vary from week to week as new issues come to market, as issues are called, converted or mature, etc. Indices are reported at www.sifma.org:

• Tax Exempt Indices include the SIFMA Auction Rate 7-Day Index, SIFMA Auction Rate One Month Index, SIFMA Auction Rate 7-Day Specialty State Index, SIFMA Auction Rate Preferred 7-Day Index, SIFMA Auction Rate Preferred One Month Index, and SIFMA Auction Rate Preferred 7-Day Specialty State Index.
  
  
• Taxable Indices include the SIFMA Auction Rate One Month Taxable Index, and the SIFMA Auction Rate Preferred 7-Day Taxable Index.

Conclusions

Though very mysterious, ARS is worth noting in the current credit environment because it can impact mortgage rates. A return to calm in the ARS market can lower mortgage rates.

According to Dr. Martin Feldstein, quoted in the February 22 New York Times, "The principal cause for concern today is the paralysis of the credit markets. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied."

The major risks associated with the ARS markets appear to be decreased liquidity and higher rates. ARS markets will be illiquid if auctions fail, presenting a problem to investors who want to sell the securities to obtain their money. In addition, auction failure may lead to issuer incurring higher interest expenses. Given that financial intermediaries are currently facing a variety of financial pressures, there has been some concern over the lack of support for the ARS auctions and the possibility of additional failed auctions. Auction failure does not mean default; it means that the bond issuer needs to refinance and look for an additional source of money or, alternatively, in some cases pay very high interest rates. The result is decreased credit availability at a time when one would like to see enhanced credit availability to avoid recessionary trends. Fortunately, there are some indications that the ARS auctions are improving, though they are far from being back to normal.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®.