One of the still unresolved casualties of the financial crisis was the breakdown in the market for municipal auction rate securities ("ARS"). Sold to many individual investors as a tax free money market alternative with a higher yield, this Wall Street "innovation" left both retail and institutional clients holding the bag when these auctions failed and the sponsoring investment banks failed to support the auctions that had once been very lucrative to their bottom lines. Investors, many of whom were assured that they'd always have access to their funds, were left holding the bag while many of the program dealers who underwrote these securities and ran the auctions were bailed out using taxpayer funds.
In the ensuing years since the financial crisis, attorneys general of many states have forced settlement agreements upon some of marketers of these toxic securities and many issues were restructured. However, there are still many hurting investors whose "money market" investment now has a maturity of 10 to 20 years with no way out. While this part of the story has been told many times, a less visible part of this story hasn't received any press. It's a tale reminiscent of the old adage, "tails I win heads you lose," where program dealers and institutional issuers always win and the investor always loses.
A Tale of Two Municipal ARSs
In the face of a failed ARS auction, one of the most critical aspects of the issue is known as the maximum penalty rate. This is the rate the issuer is required to pay to the holder of the ARS in the event of a failed auction. Let's say an investor did his due diligence and found a municipal ARS that paid 18% in the event of a failed auction. Hey, at that rate many investors would be happy to give up liquidity and hold the security to maturity. Unfortunately, it may not work that way.
Let's examine two weekly reset, municipal ARS, both issued on behalf of companies that are now part of National Grid (NGG). Each has Goldman Sachs listed as either the sole program dealer or a co-program dealer responsible for managing the auction:
Ultimate Underlying Credit
NYS Energy Research and Development Authority
Keyspan Generation, LLC, a National Grid Company
Goldman Sachs (NYSE:GS)
NYS Energy Research and Development Authority
Brooklyn Union Gas, a National Grid Company
Floating Rate: 250% of 30 Day LIBOR
Each week, a new interest rate is determined through a dutch auction where the lowest rate necessary to clear the buy orders, net of the sell and hold orders, determines the rate the issuer pays to bond holders for the upcoming week. Prior to the financial crisis, the detailed auction results were not disclosed to the investing public. However, with the typical rear view mirror mentality that U.S. regulators seem to operate under, this information is now available to the general public.
Digging through the auction data made available by the MSRB, an interesting revelation comes into focus. It is often the program dealer that sets the maximum rate the issuer must pay, not an arm's length auction process as one would expect when purchasing and holding this security. In the auction below for Issue A, a seller came in for $400,000 while there was only a single bid of $50,000. If Goldman Sachs didn't step in and bid for the entire issue at .90%, National Grid would have been forced to pay the "maximum penalty rate," a whopping interest rate 18% for the upcoming week:
In this case, Goldman Sachs is effectively capping the maximum rate with its bid for the entire issue $41,225,000 at .90% and protecting its institutional client, National Grid, at the expense of the holders of the issue.
Now let's look at the auction results on the same day for Issue B. Many investors have been trying to get out of this supposed liquid investment since the onset of the financial crisis without success. In the auction below, there are sell orders totaling $5,375,000. Yet, with a floating penalty rate set at 250% of 30 day LIBOR, or 0.456%, Goldman Sachs has no reason to protect National Grid and it certainly has no interest in helping the stuck investors. As a result it makes no bid and sellers are stuck with no way out week after week after week as auctions continue to fail.
So what we have here is the typical story of the inequity of the financial crisis. A major U.S. Bank with a credit line to U.S. Taxpayer financing through the Fed window, a company that was bailed out by the U.S Government protects a foreign institution from a structure that could potentially cost it 18% on $41.125 million. Yet, in the case where investors could use some assistance from their flawed financial instrument, Goldman and National Grid are nowhere to be found.
Would it be too much to ask for Goldman Sachs and National Grid to get together, restructure and retire Issue B (it should be easy enough in this low interest rate environment) while at the same time helping holders of $55,000,000 in their illiquid "money market" investments?
What am I thinking? ... forgive me for the thought. This is Wall Street, after all.
Additional disclosure: These are the personal views of Wall Street Titan and should not be used for your investment decisions. This article is believed to be accurate but no guarantee as to its accuracy is implied.