The New and Improved Auction Rate Securities

Wall Street’s ability to reinvent itself along with the premise that any package can be sold for more than the sum of its parts is just as dependable as the unveiling of the new and improved Tide (PG) laundry detergent each year. Most of Wall Street’s packaged goods are no more valuable to their clients than the faux improvements to consumer packaged goods. But profits in packaging are the reason both exist, not to create real value for Wall Street’s or Main Street’s customers.

The Wall Street Journal’s “New Security Shifts Risk to Borrower” reports that Citigroup (C), Goldman Sachs (GS) and Morgan Stanley (MS) have introduced the new and improved auction rate securities (ARS) to the municipal bond market. They just cannot believe that long-term debt can’t be masqueraded as short-term debt for a profit. The target audience is the tax-free money market funds. These funds are rightfully skeptical.

I have a history of commenting on the original ARS: "Auction Rate Securities: Who’s to Blame?", "Retail Investors stuck with Auction Rate Securities", "Auction Rate Bonds are not Cash Equivalents" and "Mechanics of Auction Rate Securities". While none of these commentaries have been favorable, I found the mechanics of the products fascinating.

The new twist is that the municipalities (borrowers) must buyback (repay) the loans if the money market funds (lenders) want to withdraw (sell). This makes the loans putable if the funds are not satisfied with the weekly “auction.” The municipalities would have between 7 and 12 months to refinance.

Theoretically the municipalities would be paying a variable interest rate based on short-term debt for a long-term commitment. But the commitment is very much one-sided; the municipalities bear both the interest rate risk and refinancing risks. The lenders only bear the credit risk. Why wouldn’t the municipalities just sell long-term variable or fixed rate debt and eliminate the early put option? If their credit rating falls, the municipalities might not even be able to refinance. The only possible advantage for municipalities would be a slightly lower interest rate as the cost lenders would be willing to absorb for the put option.

The interest rate would be reset every week based on a short-term municipal debt index, rather than an actual auction. So there is no risk of a failed auction. With the risk removed from the underwriters the fun can really begin. I’m sure there will be all types of protection available for sale to both the borrowers and lenders. Interest rate swaps that the municipalities cannot hope to comprehend would just be the beginning.

Surprisingly, the SEC has approved this product for money market funds. Apparently the temptation of the pay-option ARM for irresponsible behavior has taught our regulators nothing. Are our municipal and state governments any more sophisticated or smarter than boom era homebuyers in resisting loans they don’t understand?

These products present unneeded risks to both borrowers and lenders with little value added for the trouble. The only difference this time around is the investment banks appear to be trying to immunize themselves.

Disclosure: Author is long C

Comments

[Perry B:]

good article, news we need to know.

Jun 16 08:27 AM

[Stung By WS:]

Wall Street now inventing a new ARS -- without ever paying back the OLD ARS! There are still thousands of defrauded small investors at Oppenheimer, TD Ameritrade, Wells Fargo and others, waiting to get back their cash from their "cash equivalent" investment after 15 months.

This is another Wall Street shell game. Keep up pressure to force investment banks to give back ARS money before they peddle the same junk to others.

Jun 16 02:01 PM

[Stung By WS:]

Wall Street is now peddling an ARS-like security --- without ever actually PAYING BACK ARS! There is still $100 BILLION frozen -- that is, taken but not returned. Small investors have not had access to the cash in their "cash equivalent" securities for over 15 months.

Wall Street has a lot of nerve. Keep up the pressure, and make Oppenheimer, Wells Fargo, TD Ameritrade and others pay back the money they took from small investors.

Jun 16 02:06 PM