Our Run-In With Auction Rate Securities - And What It Taught Me About Markets

Over the past month, my wife and I had a run in with the auction rate security market. We emerged unscathed but there were a few uncomfortable moments and they taught us a few things about markets that we had sort of understood but not at a gut level. There's nothing quite like a few sleepless nights to teach you lessons you'll keep for the rest of your life.

It all started almost a year ago, when we parked a significant amount of cash in tax free municipal bonds. The cash is intended to be used to fund a purchase we plan to make later this year. We wanted the money to be totally safe, very liquid, and produce income that we didn't need to deal with the hassle of calculating and paying estimated taxes on. So with the advice of some experts on tax free bonds, we purchased three auction rate tax free municipal bonds.

For those who don't know what an auction rate security is, here's a short explanation. (If you want a longer one, click on the link in that last sentence and Wikipedia will do its magic for you.) Auction rates are generally long term bonds (corporate or muni) that have their interest rate reset every week via an auction. This does two things. First, it allows the borrower (the corporation or municipal government) to pay short term rates on a long term security. And that can be very beneficial to the borrower. It also allows the purchaser of the bond to have much higher liquidity because the auction rate security is re-auctioned every week. So every week, you have the opportunity to say that you want out and you get out. At least in theory.

We've owned auction rate munis on and off for almost 10 years so it's not like we were new to this market. But the amount we parked in auction rates last spring was significantly more than we'd had in auction rates in the past. I understood how they worked, but honestly never paid much attention to the specifics.

One specific provision of auction rates that is really important, but I honestly knew very little about until the past couple months, is the penalty rate (or maximum rate). If a bond auction does not generate enough demand at any time in the life of the bond, it reverts to a long term bond and pays a maximum rate of interest.

Until the recent problems in the fixed income market brought on by the subprime mess, the auctions of these securities didn't generally fail. There were a ton of buyers in the market and there was plenty of liquidity. But several things happened that have changed the auction rate market, at least temporarily.

First, and most importantly, the issuers of auction rate securities generally get the bonds insured against default in order to improve the credit quality and rating of the bonds. These bond insurers have gotten into trouble in the subprime mess and they are in various stages of financial distress. Without the security blanket of the bond insurer, many of these auction rate municipal bonds look a bit riskier and so the demand for them has gone down.

In addition, there is a general de-risking going on across all of the capital markets with investors opting in favor of really safe investments right now. So that further dampened the demand for the weekly auctions.

Starting late last year, auctions starting failing. And they have continued to fail for most of the first two months of this year. Investors who were sold a "safe and liquid" bond are waking up to find out that they now have a "pretty safe and illiquid" bond. They are also finding that the interest rates they are now getting have gone up.

So when I got a call from the person who manages our bond portfolio about a month ago telling me that "your bonds have not yet failed an auction but you should know that the risk of it happening has gone up", I started paying attention. I did my homework and got a list of the three bonds we owned and drilled down into the details of what they were. I focused on the borrower, the borrower's credit, the rating, the insurer, and most importantly the penalty rate. All of our three bonds were issued by government managed utilities in NYC (like water and sewer). All were AA rated borrowers and AAA rated by virtue of bond insurance. All were insured by insurers who were in the news. But most importantly, all had penalty rates above 12%, with one at 15%.

We thought long and hard about what to do. We went for a week or two where we watched to see if the bonds would pass the auctions. In every case they did. As we noodled it over, we came to realize that the auction rates we held were really solid securities because of the penalty rate. Even though we needed the money to be liquid later this year, there were investors who would love to own the securities at a maximum/penalty rate of 12-15%. So there were investors coming into this market almost hoping for an auction to fail. That provided the necessary liquidity to the auctions of these specific bonds.

But even though the bonds were solid, the rates they were paying had gone from 3% in the fall of 2007 to over 7% in February. That's how messed up the auction rate muni market had gotten. We were getting paid over 7% tax free for bonds that were solid. And the borrower, in our case the local government utilities, just saw their interest expenses go way up.

Ultimately, we decided to bail out of the market and now our cash is sitting in a money market fund paying a fraction of what we were getting in the auction rate market. But we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year. And so, along with a lot of other "safety first" money, we left the auction rate muni market last week.

The most interesting class I took at Wharton where I got my MBA was called "speculative markets" and in that class I learned that markets include different classes of investors. There is the safe money, the hedgers, and the speculators. For example, when a company (like Yahoo) gets a takeover bid and the stock soars, the safe money generally leaves the stock, takes its gain, and the stock trades into the hands of speculators who are now taking the risk that the deal will in fact go through. They are a different kind of investor who is getting paid to take those kinds of risks.

The same thing has happened to the auction rate security market, at least temporarily. The safe money (at least, our safe money and I am sure many others' safe money) is gone from that market. And in its place are speculators who are willing to take the risk of illiquidity and even default (which is very low in the muni market) in return for getting tax free interest rates of 7% to 15% (which is the equivalent of 10-20% taxable).

What was my big takeaway from this whole affair? When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates. When they are priced appropriately, the market works. When they are not, the market doesn't work. Thankfully the people who helped us construct our auction rate portfolio understood this. Now we do.

Comments

[Lisa:]

Excellent article.

2008 Mar 05 09:25 AM

[BondGuy:]

The correct lesson would have been to trust NO ONE on Wall Street. The holders of these notes were deceived and abandoned by the investment banks and brokers. You got your money out, but many didn't. Moreover, the market is still illiquid, even for bonds with higher resets.

2008 Mar 05 09:32 AM

[RKO:]

Thanks for sharing Fred. Helped me understand what exactly is going on away from the equities market.

2008 Mar 05 09:40 AM

[john haskell:]

Fred, you say that the monolines are in financial distress. But MBIA and Ambac management say that it is just a tempest in a teacup, nothing can go wrong...go wrong...go wrong. Is it possible that Bill Ackman is right? Blasphemous to even breathe the thought, I know- but I am starting to wonder.

2008 Mar 05 09:44 AM

[David Jackson:]

Terrific article, Fred. I've added a link to it in the "Further Reading" section of our ETF Selector page for muni bond ETFs and CEFs:

seekingalpha.com/artic...

2008 Mar 05 09:44 AM

[Ex15:26:]

As a former trader of a money market portfolio in a hedge fund at any given time, I owned more than $800MM of these. There generally isn't a concern that your cash-flows are in doubt because there are several safe guards that are sold with these products.
1) Double or triple collateralization (of loans to the securitized pool-if you were buying a student loan auction rate preferred)
2) The bond insurer guarantee - THEY GUARANTEE THE CASHFLOWS and principal at the time it is due, there is no acceleration of principal.
3) An implicit guarantee by the broker that sold it to you that the bank (MER, Morgan, CIBC, LEH, will step in and prop up the auction).

All of these are great in a liquid and healthy market. I agree that you are very fortunate that you had a broker that kept you informed of the drying up liquidity in your auction, but if I were him, I would have advised you to bail immediately. 7% or a grossed up 9% taxable return for something that could have been temporarily in-accessible is not compensation enough. As any bank would tell you - Cash is king right now. As we all know, this is not a healthy market - and therefore going back to the guarantees above;

3-Your broker or the bank has had their fill of stepping in a being a back stop for every auction and has let their client down by not making a liquid market.
2- the bond insurers are not there to step in (possibly).
1)- You must rely on the solvency of the underlying credit. If you can imagine on each muni - this would be very tough to do on an institutional scale and this has been the reason why the market happily bought the whole idea of the bond insurers. You must have a real comfort level with the over-collateralization in the structure as well and hope that it will get your money back when due.

There are still a tremendous amount of risks in this market. The real problem is that the other hedge funds that will be attracted to these supernormal returns (like mine would have been) will then turn around and margin these AAA credits at 5:1 ,10:1 or 20:1. These guys will then be able to take that cash and invest in other things. The risk comes in here when you have a situation like Thornburg where they believe their underlying collateral is great, but the market believes it stinks and requires more margin.
As a fund or mortgage company or investor, what do you do if all of your bullets are spent (cash) and you get a margin call because your counterparty suddenly thinks your collateral is worthless? (you can't get a real mark in some CDOs and some munis right now). Yes, you have to sell that great collateral to make a margin call and save the rest of your portfolio. As you mentioned, there are few buyers - so guess what, you have to take any price that is on the market, especially if it is a big position.....
What does that do to the rest of your position that you don't sell? Further reduces the price, causing further margin calls.
This is exactly the same thing that is going on in the subprime CMO market. Funds that believe that they have little or no chance of getting hit with defaults have bought and are now having to liquidate and are getting in further trouble.
So if leverage is the cause of this, why do they leverage? They must if they are to provide the types of returns they desire and have promised.

Supernormal returns are great - but remember, the market is demanding them because the perceived risk is very high or there is no money out there to use to buy them. Smart money is willing to do the research and understand the downside to capture these, but as we've seen - many smart guys are getting blown up by this crisis so watch out!

2008 Mar 05 10:17 AM

[JReality:]

I still have large positions in Auction Rates because I don't need the cash right away, and I'm getting great yields on quality issues. The party won't last forever because they will start to be called back by the issuers as early as a few weeks from now.

Even though the problem is ultimately the brokers and bond insurers fault (for getting involved with risky investments that caused this crisis), the taxpayers will ultimately be footing the bill. Many states also purchased "interest rate swaps" which were supposed to hedge them against rising short-rates in general, but did NOT hedge them against this particular situation. The investment banks sold the munis, and ultimately the taxpayers, a bill of goods!

2008 Mar 05 12:25 PM

[User 160537:]

Fred, below is a quote from your article dated March 5, 2008. Late last week was February 28th and 29th. How did you get out of it then? Please, I need to do what you did!! I called my broker Feb 15th to get out of them but could not get a single auction to go through then or since then. What's up with your success????

" But we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year. And so, along with a lot of other "safety first" money, we left the auction rate muni market last week."

2008 Mar 05 02:49 PM

[JReality:]

User 160537, maybe the author's ARS positions were higher underlying quality or had a higher reset rate than the positions you own?

2008 Mar 05 04:49 PM

[arenas:]

Excellent explanation. Why wouldn't taxable trusts with a long horizon invest in these securities?

2008 Mar 05 05:03 PM

[.crazylegs..:]

@arenas - because the rates won't be around for any solid credit for any length of time. you'll buy these and hold them until the municipality refinances out of them. the greater the penalty rate, the more incentive the institution has to refinance.

One broker I use to custody client accounts will let me trade them to another family account, but they wouldn't let me buy the bonds from them. So I'm buying a tax free bond in an IRA account and the yield is better than the taxable municipal I had to sell to make room. Weird illiquid market right now.

2008 Mar 05 11:40 PM

[Harry Newton:]

I have $4.5 million of Auction Rate Preferreds. They are different to the individual issuer bonds talked about above. Virtually all auction rate preferred auctions have failed in the past three weeks. Thousands of people (including me) are now looking at their "cash equivalents" as long-term, infinite-maturity bonds. This is intensely annoying, especially to owners who held their April 15 tax payments in these ARPs and now can't get to the money. In recent days I have been writing about ARPs on my web site, which you can now reach (for free) AuctionRatePreferreds..... If you own these things, please visit my web site and email with me (my email address is on the web site). I talk to ARPs owners every day and every day we collectively think of things we can do. I am not saying I have "the solution." But we have ideas. I am not a lawyer. I am not looking for clients. I am looking for a way to get at my cash. Thanks -- Harry Newton.

2008 Mar 06 12:30 AM

[JReality:]

Harry Newton, the link within your message doesn't work without the 'www', however www.auctionratepreferr... works.

2008 Mar 06 03:24 PM

[dedugs:]

So how did you get out?

2008 Mar 07 01:02 AM

[Alvin:]

Hi Fred,
Who's your broker and does he have any more AA / AAA rated ARS yielding 7-15% for sale? I would be quite happy to hold illiquid bonds for a few months while the issuer tries to rfinance (even years if the yield is 15%!).

2008 May 21 10:25 AM