Monday, February 25, 2008

failures for short-term municipal auction rate securities continued apace last week, by some reports still as high as an 80% failure rate. but some of the results of the chaos of this $300 billion market are starting to be felt, and they prove a number of things that we already knew.
  1. the individual investor who relies upon the expertise of his broker was misled about the nature of this investment but probably will have no recourse.
  2. the municipal entity, relying on its broker was misled about the nature of the debt instrument but probably will have no recourse.
  3. the work and costs to restructure (and probably ultimately retire) this instrument of the municipal bond markets have already begun to skyrocket, and those big fees that are generated will accrue entirely to that same broker.
so yeah, the banks almost always win. i mean, does ANYONE really think the fed works for anyone else? take a wild guess as to who "owns" the federal reserve recap, the muni bond market also offers an auction-rate type of security. that is, long-term municipal debt obligations are auctioned off either in 7-, 28- or 35-day periods, where the interest rate on the note is "reset." since this type of obligation was created in 1987, only 44 of the thousands of auctions held to reset interest rates on these bonds have failed.

by "fail," we mean the auctions did not attract enough buyers to reset at the prevailing market rate; after failing, the notes are reset at a preset maximum auction limit, fixing the interest rate and locking owners of the bonds into holding those notes -- at least until the next auction. In the past, investment banks running these auctions have operated like the old-time specialists in stocks on the stock exchanges: they would "guarantee" liquidity by purchasing the leftover quantity of bonds that went without bidders for a particular issue, hold them on their own books to either enjoy the added interest of a less-wanted (and therefore higher-rate) bonds or sell those bonds to clients out of inventory at a profit. while this system has been mostly unregulated in the past, it worked well enough -- investors had the liquidity of entry or exit "guaranteed" at designated reset periods, while municipal entities had the advantage of issuing long-term debt but in essence only paying interest at lower short-term rates. it worked well enough, that is, until the major investment banks, led by gs, c and ubs decided that their battered balance sheets didn't leave room to support this market anymore.

as failures mounted and continue to mount without bank investment to support these auctions, investors and issuers alike are being slammed. brokers have peddled these instruments to clients as being the "equivalent" of cash, and while they have been effectively as liquid inside of reset periods in the past, there is a fraud that was committed in representing these securities in this way. auction failures
have locked investors into instruments they do not necessarily want and taken liquidity away. it has forced many to sell other assets that they may not have wanted to sell to find cash they thought were told would be available. it may have had an effect on the recent weakness of the stock market. i certainly think it's contributed. remember, these bonds are sold to the most well-heeled investors and institutions, mostly in units of $100,000. these individuals will be ok, however, as they've at least enjoyed a higher interest rate than normal from these failed securities and we are still pretty sure that the underlying issuers are rock-solid and will not default -- in the end, investors will get their money out with some extra interest to boot. still, that lack of cash flow has been a burden, and it looks like investors will have no recourse of protest.

it's been worse for the municipalities, because failures have caused the interest rate that they've been paying to soar as much as 5 times their expected rate. how will they recoup the extra interest payments they'll now need to make? for new york's metro transportation authority, toll hikes are to be expected. for education loan programs, higher interest for students and maybe tougher standards for loans. for townships, of course, there will be increased taxes.
legally, the investment banks aren't obligated to provide liquidity in these markets, although they as much as promised it. morally, well, the banks, in essence, are abandoning some of their best customers, their high-wealth clients and institutions and state and county municipalities in order to reserve capital for their own balance sheets. while officials will now probably take a close hard look at the lack of regulation and rules in these markets, they'll be too late -- these wholesale failures will probably end the auction-rate securities market and these instruments entirely in a year.

but here's a key point - the banks are cashing in big-time on the necessary restructuring of this municipal market. as issuers balk under the pressure of huge interest rates from failed auctions, they are searching to restructure that debt into variable-rate and fixed-rate notes and retire these "loan-shark-rate" notes. as so many of these auctions continue to fail, hundreds of entities are rushing into the other debt markets to cover. as a result, the costs associated with issuing debt in these new markets are going up. standby purchase agreements, which are basically guarantees of a successful auction of new fixed or variable debt, have tripled in the past month, from around 15 basis points to nearly 50. the costs of a letter of credit, which not only guarantees a successful auction but also puts the bank as a guarantor of the issuer in case of default, have also zoomed. these markets, although they've been small in the past, are about to become a big source of business for the investment banks going forward as they get swamped by needy issuers. it may be a bit much to lay all the blame on the large banks for this mess -- traditional bond reinsurers like abk and mbi have inspired little confidence to date in the bonds they are backing and left the banks holding notes they normally would have brokered away. those, combined with a miserable year of losses from credit writedowns that may or may not be over, make it difficult to hold the banks entirely responsible in this case. yet the quickness with which the banks abandoned their investors and issuers and exited these markets is astounding. in addition, the increased fees they'll reap from the now necessary restructuring of these notes (a restructuring they helped inspire!) is mind-boggling. investors and municipalities may lose, but in the end, the banks almost always win.

long gs, c and mbi

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