Liquidity Freeze

Since I have been away...

Sat, 24 May 2008 15:13:45 -0500

Here is the Article from Today’s Barrons:

ALL AUCTION-RATE SECURITIES are not created equal. How much money investors get back from these instruments devastated in the recent credit crisis -- and how quickly -- will depend on who issued them.
Some investors in the auction-rate securities sold by a municipality or a taxable, closed-end mutual fund already have gotten their money back or may do so within weeks. Those holding issues from tax-free, closed-end municipal-bond funds will likely see some money back before long. The folks running these funds are frantically working to come up with a replacement security, but some need approval from the Securities and Exchange Commission and the Treasury Department. That could take a few months, but it should happen.
In the toughest jam are investors who purchased auction-rate securities sold by a student-loan trust or a collateralized debt obligation -- about a third of the $330 billion market. Many are receiving little or no interest, and might not get their money back for years.
Auction-rate securities, once considered a money-market alternative, are either debt that matures in 30 or 40 years or perpetual preferred stock, which never matures. Until recently, ARS were often considered short term because an auction was held every seven, 28 or 35 days to set a new interest or dividend rate. Participants -- both mom-and-pop investors and corporations seeking yields on their cash -- assumed they could sell their securities at auction to new buyers.
The system worked until February, when sellers outnumbered buyers and the auctions began to fail. Investors, who normally held onto their securities at auction, were now looking for the exits -- and finding none existed. In the general credit crisis, buyers and sellers grew skittish about companies that insured municipal ARS, rising default rates on student loans and CDOs' opacity.
INVESTMENT BANKS HAD THEIR own problems. They were taking billion-dollar write-offs related to the turmoil in the subprime-mortgage market and were stuck holding billions of dollars of leveraged-buyout bank loans. Some issuers believe the bankers were unwilling to be the buyers of last resort at the auctions because their own balance sheets were already stretched to capacity.
The upshot: The ARS market came to a grinding halt. Investor lawsuits against brokers and fund families are flying. (Issuers generally note that the brokers had no legal requirement to provide liquidity to the market and the liquidity risks were laid out in prospectuses.)
Now the nuances of who's likely to get money back and when are understood by investors in the secondary market, says Barry Silbert, founder and CEO of Restricted Stock Partners, which runs a trading platform that's handling a lot of the transactions. The longer it takes to get money back, the greater the discount buyers require to purchase the securities. For instance, municipal ARS trade at only a slight discount, 92-98 cents on the dollar, says Silbert. At the other end of the spectrum are CDO-issued ARS that can trade for about 50 cents on the dollar.
Ironically, there doesn't seem to be any effort underway to repair the auctions. Some issuers are being told by their investment bankers that the market is dead. But not everyone agrees.
"Investors should be demanding that the auctions be unfrozen by the issuers and their brokers," says Joseph Fichera, CEO of Saber Partners and a former investment banker involved in the market. The brokers and issuers could be providing more transparency about who is bidding and at what price, as in U.S. Treasury auctions, he says. They could also offer higher rates to compensate for liquidity risks, and more than one broker should be involved in each auction to bring in as many investors as possible, in Fichera's view.
Four months later, the municipal auction-rate market has regained a bit of liquidity, while other auctions remain paralyzed. Below we've laid out the main market segments and their prognoses.
Municipal Issuers
Issuers like cities and toll roads had about $165 billion of ARS outstanding at the start of the year, or about half the ARS market. When the auctions failed, rates on some securities jumped as high as 15% or 20%.
Rather than make such lofty payments, many municipalities chose to refinance their ARS with new debt. Bloomberg estimates that north of $63 billion of municipal ARS have been refinanced and that auction-rate holders were bought out without losing any money.
The high penalty rate also attracted other investors. As a result, about half of the municipal auctions are working again, with interest rates in the 4% to 5% area.
Some municipalities, like the Bay Area Toll Authority, were smart enough to require underwriters to agree to keep the rate on any failed auctions low. As a result, the rate on the authority's $720 million of ARS remains in the mid-3% to low-4% area despite failures, says Brian Mayhew, CFO of the agency that operates seven bridges. He'd like to refinance the ARS with variable-rate-demand bonds backed by a bank liquidity facility. The problem: finding banks willing to provide the facility at a reasonable cost. If Mayhew can't, he may leave the failing ARS outstanding since he's got a low rate.
So, in the municipal market, investors need to know their issuer. A large issuer with a good rating and ARS yielding more than 10% is likely to refinance. A small issuer with poor ratings or one with a low ARS rate may be inclined to leave the securities alone.
Taxable Closed-End Funds
These funds typically sell stock in the public market and use the money to buy equities or taxable bonds, like corporates or mortgage-backed securities. To boost returns, the funds often use leverage, selling auction-rate preferred stock or bonds and using the proceeds to buy more securities.
Closed-end funds are allowed to sell $1 of preferred securities for every $2 of investments they hold. But funds can offer only $1 of debt for every $3 of investments they hold. So by selling preferred securities, the funds could increase their leverage more than if they had sold debt.
Auction-rate preferreds were attractive because they had low, money-market-like yields on financing that was really long term: perpetual preferreds never mature.
At 2008's start, about $33 billion of auction-rate perpetual preferred stock was outstanding from giant fund families like Nuveen, Eaton Vance and BlackRock.
When the crisis struck, regulators told the funds they couldn't help the auction-rate preferred holders at the expense of the equity holders. So a fund couldn't replace the preferreds with high-cost debt.
Likewise, funds that were leveraged 2-to-1 couldn't replace the preferreds with debt because they would have had to delever to the debt requirement of 3-to-1. Doing so would also have reduced the payments, known as the net interest income, to equity holders.
So far, some of the less leveraged taxable funds have replaced their ARS with debt. At Nuveen, seven of 13 taxable funds plan to replace $1.7 billion of their $4.3 billion of auction-rate preferreds with alternative financing. The key again is finding banks willing to provide loans or guarantees.
The industry has asked the SEC to change the leverage requirements, so that debt financing can be leveraged 2-to-1, like preferred.
So far, about 40% of the ARS sold by taxable closed-end funds has been or will be refinanced, estimates Mariana Bush, a Wachovia Securities analyst. Many of the ARS yield about 3% now that the auctions have failed. That's not great for a long-term security, but it's not bad relative to a 2% rate on some certificates of deposit. Investors who can hold on for a year should consider doing so. There isn't much credit risk, and north of 80% of these securities are likely to get refinanced in the next year.
Municipal Closed-End Funds
These funds, which own municipal bonds, face all the above problems with an added twist. Dividends on auction-rate preferred securities of municipal closed-end funds are tax deductible. If the same funds sold debt, the interest payments wouldn't be deductible, and their interest rates would have to be higher.
So fund families that sold closed-end muni-bond funds have been scrambling to create a new preferred security. At Nuveen it's called Variable Rate Demand Preferred. At Eaton Vance, it's Liquidity Protected Preferred stock.
The securities vary but generally involve a frequent auction to set the dividend rate. If the auction fails, existing holders would have an option to put the security back to a bank that would agree to hold it for a preset term. On some securities the preferred dividend rate would rise so high the fund family would be forced to repurchase them from the bank.
Some funds have asked the SEC to allow money-market funds to purchase the security because it has a put option. If so, that would bring a huge new buyer to the market and the added liquidity might get the auctions working again. "We expect to be able to respond affirmatively fairly quickly in the next couple of weeks," says Robert Plaze, associate director, division of investment management at the SEC.
That said, the security faces tax questions. Will Treasury deem it preferred stock or debt, given the fund will ultimately buy it back? And again, banks must go along.
Municipal closed-end funds have about $28 billion of auction-rate preferred stock outstanding. Only $2 billion has been refinanced and the auctions are failing. Our guess is the fund families and the government are motivated to find a solution, though it might take up to a year. But since these securities sell in the secondary market at only 82 cents on the dollar, with minimal credit risk, it seems worth waiting.
Student Loans
Some of the thorniest issues have arisen in the student-loan auction rate market, where almost all of the auctions continue to fail and only $1 billion of the $85 billion outstanding has been refinanced.
In recent years private companies have originated federally insured student loans and financed them by selling them into a trust. The trust in turn sells some medium- and long-term debt and some ARS.
There are few refinancing options. Financing costs in the student-loan market have gone up sharply, so old trusts can't be refinanced. Congress and the Department of Education have agreed that the DOE can buy new student loans from private companies and make short-term loans to newly created trusts. But the DOE hasn't addressed ARS' biggest problem: illiquidity.
One option: The Federal Financing Bank, a unit of the U.S. Treasury, could provide a standing bid in auctions of London interbank offered rate, or Libor, plus half a percentage point, to give investors a way out of an auction if they desired, says Jamie Wolfe, CFO of NorthStar Education Finance, a graduate-school lender. It has $4 billion of student loans in trusts that were financed in part with $800 million in ARS that are frozen.
"The priority now is that students going to college this fall have access to capital," says Restricted Stock Partners' Silbert. Solving the problems may take awhile.
Some of the initial rates from failed auctions were 10% or more. But as more auctions fail, a mechanism kicks in that prevents the average rate from going so high as to push a trust into default. As a result, some student-loan-auction rate securities offer 0% rates to investors, but the rates tend to average 3% over time. And that doesn't encourage the trusts or the student-loan companies to fix the problem.
Collateralized Debt Obligations
In hindsight, the riskiest ARS were sold by the CDOs. Some CDOs bought fixed-income investments and financed them by selling ARS.
The problem is that most ARS holders have no idea what the CDOs own because the information is not disclosed. Some may have invested in the highly rated pieces of subprime-mortgage securities. Others have sold a put option to insurers that require the CDO to sell its investments and buy the preferred stock of the insurer.
There are about $20 billion of CDO ARS that are in failing auctions and illiquid. These ARS won't be redeemed. They'll stay outstanding until the CDO winds down, either because it's collapsing or because the investments it holds are maturing. Investors should push their brokers to find out what investments their CDO owns in order to make an educated decision about whether to hold or sell.

Not Much News

Sun, 11 May 2008 17:06:37 -0500

Not much has changed over the last week. Or at least no game changers. A few more taxable funds announced redemptions. Maybe a good time to step back and access what’s happened over the last month. Since April 4th, approximately $10 billion in taxable CEF ARPs have been redeemed, or a redemption has been announced with relatively solid plans for redemptions. I am waiting for some of the more vague announcements of intentions to announce specifics.

This is between a third and a half of the taxable CEF ARP’s, based, since over half the total are tax exempt. Some of the fund companies are releasing and discussing their intentions, while others like Hancock didn’t say anything before they made a redemption announcement. Since we are still getting a trickle of announcements, I assume that nothing has changed regarding the viability of using debt to refinance.

The two big hangups -- the difficulty of using debt for full redemptions on taxable and the difficulty of a solution for the tax exempts -- don’t seem to be resolved. Having worked in a regulated industry, people generally underestimate the length of time it can take to obtain full regulatory approval for anything new. Especially when there are multiple regulators.

There are also the oddball funds that will merge (like Western Asset Management) rather than refund, which requires shareholder approval. Or some other offbeat way. Overall the pace of redemptions seems reasonable - $10 billion in 6 weeks. Watch for Nuveen to be the bellweather, and when they come up with something for their tax exempt funds, things could pick up quickly.

The Smart Money

Tue, 6 May 2008 03:04:17 -0500

What about all the Corporations. The ones that hold $100 billion of these? Didn’t they get the memo? A little background first.

The accounting profession has been talking about the problems of classifying these as ‘cash or cash like’ assets on their balance sheets. According to Dealbreaker, the auditors themselves may have triggered the problem:

For close to three years the Big Four accounting firms have been advising their corporate clients to change the way they account for auction-rate securities....Early last year the Financial Standards and Accounting Board decided that the “cash equivalent” designation was too open to confusion and abuse and recommended it be eliminated from cash flow statements. Many corporate treasurers and investment banking professionals who spoke to DealBreaker believe that this helped trigger the sell-off of auction-rate securities at the end of last year and the beginning of this year.
Others point to an even more recent accounting phenomenon—an advisory issued in January by Deloitte that warned auditors that “many issuances of auction rate securities have been adversely affected by the turmoil in the credit markets; thus, their current fair value is at a discount, sometimes substantial, from par value.” As auditors began to inform client corporations that they were going to have to record impairments of their auction-rate securities, corporate treasurers decided to unload this new source of credit market damage to balance sheets. Even corporations that had changed the accounting treatment of the auction-rated securities much earlier had not really paid much mind to them.
Post Enron, the remaining firms aren’t willing to take another bullet, and like to emphasize this point. The competition is down to four, after Anderson was taken out and shot. They are fat and happy with their Sarbox consulting fees. In fact, it can be more lucrative to do consulting then the actual audit, since the auditing firm is conflicted out from consulting. It’s just a different world.
So, some firms were actually getting out of them before year end financials, just because they didn’t want to deal with accounting issues. No one wants to go to the mat with their auditor or have to restate over something like this.

One of the strengths of the CEF’s ARPs is the credit quality is strong, and it can be quantified with simple division. The maximum leverage ratio is essentially overcollateralization.

But we had the municipal bond insurers getting crushed, and insured muni issues were no longer bullet proof regarding credit quality. This led to some auction failures, as noted by Deloitt on Jan 11th.

A quick glance at the timeline shows some businesses moving to more solid ground, general pressure in the credit markets, and a few failures. At the same time, yields increased. There was not much discussion about systemic auction failures.

Calamos MM Debt Redemption

Fri, 2 May 2008 15:23:45 -0500

Calamos issued a press release on a redemption of an additional $300 million of ARPs. The interesting thing is the form of the refinancing. According to Calamos:

Calamos has secured an alternative form of borrowing that will enable, based on current market conditions, CHW to redeem approximately 85.7% or $300 million of its outstanding ARPs at their par value. The refinancing comes in the form of the first money market eligible extendible note to be issued by a closed-end fund.
Sounds good. It’s MM eligible which makes sense, since it’s AAA. The MM’s are dipping their toe in the water.
Nevertheless, it is still debt, which means that they haven’t solved the problem of creating a a preferred security with a put option (the ‘VRDP’s’ which would allow them to clear the deck, regarding leverage and also start the process for tax exempt refinancing.

The Wells Fargo Method, Maybe

Thu, 1 May 2008 23:09:40 -0500

OK.....after looking at the UBS method, I found this on another blog.

Below is how a typical ARPs Redemption works at WFI (Wells Fargo Investments) 1. The Closed-End Fund company announces it is redeeming 50% of their fund’s ARPs or $75 million.  2. The Fund company notifies DTC of these details including the effective date of the redemption. 3. DTC informs WFI of the number of shares that must be redeemed. 4. WFI then utilizes Thompson’s Lottery Program to select shares to be redeemed that are held by WFI clients. 5. WFI client holdings are entered into the Thompson redemption program. Each share they hold represents 1 opportunity to be selected for redemption. For example if a client holds 10 shares, they are eligible to be selected 10 times. A client with 30 shares will be eligible to be selected 30 times. 6. The redemption program randomly selects shares until the total number selected equals the amount of shares WFI must redeem (per Step 3). 7. The shares selected for redemption are assigned a new CUSIP and remain in the client’s account until the redemption date when they will be exchanged for cash.

This is interesting. Thompson’s Lottery Program? That aside, this is fundamentally worse then the UBS method described below.

They are both unbiased, meaning that everyone has the same probability of getting their shares redeemed.

However, The UBS program has lower variance. Now, in a regular lottery, people want high variance. Pay a buck, win a million. However, holders of ARPs want an unbiased method with MINIMUM VARIANCE. I could go through this in detail (with effort), but it is easy to see that the UBS program has 0 variance for whole shares, with the only variance in the fractional shares. OK....I get that this isn’t something that happens so frequently that it has been optimized. For typical bonds, it isn’t *that* big a deal -- and half the time, people don’t want their bonds called. But this is a time to make things as transparent as possible. Taking a chance on a fraction share is intuitively understandable, since that’s the reason for a lottery in the first place. But adding a little more randomness to the process is just another way to make people unhappy. Or half of them.