Finally, ARS holders can wait for the issuer to refinance. Because the penalty rates on municipal ARS were so high, more than half of the securities have been refinanced, says Chakford. The outstanding municipal ARS have either very low maximum rates or weak issuers. But the House Financial Services Committee is discussing temporary liquidity facilities or a federal guarantee that would enable municipal issuers to restructure the debt. As for student-loan-backed ARS, few issuers are refinancing, Chakford says, because the term ABS market is dislocated and fixed-rate financing is prohibitively expensive.
Meanwhile, the Municipal Securities Rulemaking Board is trying to make the market transparent. Broker-dealers now have to provide the MSRB’s Electronic Municipal Market Access system with information on interest rates, date and time of auction, and whether the auction succeeded or failed. (As of early June, three out of every four auctions were still failing.)
The MSRB has also drafted a proposal, out for comment, that would require dealers to submit disclosure documents, which include information on liquidity provisions as well as bidding information detailing whether or not the dealer bid for its own account. “I would view that [last item] as a critical piece of information,” says Justin Pica, director of uniform practice policy at the MSRB.
Information was in short supply for investors in auction-rate debt. But without governance improvements, firms could easily wind up in this spot again. “Right now, many audit committees are spending a lot of time talking about investments that are under water,” Pan says. “We think such discussions need to be a regular item, so companies don’t let their guard down.”
Vincent Ryan is a senior editor at CFO.
ARS investors missed key signs of impending trouble.
Plenty of “canaries in the coal mine” foretold the dislocation of the auction-rate securities (ARS) market, says Courtlandt Gates, CEO of Clearwater Analytics, makers of a portfolio reporting tool. As early as 2005, the Big Four auditors told accounting clients that auction rates could no longer be classified as “cash equivalents.” (The average ARS had a maturity of 24 years.) In 2006, the Securities and Exchange Commission penalized 15 securities dealers in the ARS market for violating securities laws, including bidding for a firm’s proprietary account without disclosing it.
And five months prior to the February 2008 failures, ARS yields spiked relative to yields in variable-rate demand notes, which are similar to ARS but differ in one critical respect: they give the investor the unqualified option to sell the bond back. By contrast, ARS lacked a “put” — an agreement that lets investors sell them at face value at any time, says Lance Pan, director of research for Capital Advisors Group. While many finance departments now accuse underwriters of having implied or even explicitly stated that they would prevent auctions from failing, contractually they had no obligation to.
“The term [dealers] used was ‘soft put,’” says Pan. “It means you have to have new investors to take your position in order to get out at par. If you don’t have equilibrium of buyers and sellers, you can’t get out” — as a number of companies now trapped in the ARS mine shaft learned all too late. — V.R.