There has been an increased focus by the media on the ongoing disruption in the auction-rate security (“ARS”) market. While failures in ARS in 2007 were limited to certain, higher-risk securities, the entire market for ARS collapsed in the first quarter of 2008.
Since that time, the spotlight has been predominantly on the lower-risk structures of ARS that represent the vast majority of the market. There are three types of ARS that fit into this low-risk basket: student loan-backed ARS, municipal tax-exempt ARS, and issues from closed-end funds.
These types of issues have a lower risk profile because they either have been structured with higher levels of collateralization or have sufficient cash flows to support interest and principal payments.
According to Karl D’Cunha, Senior Managing Director at Houlihan Smith & Company, a firm that specializes in the valuation of ARS:
These type of low-risk ARS are failing auctions because of a lack of liquidity in the market, not because of deterioration in credit. In other words, it’s a liquidity issue versus a credit issue.
This highlights an important point: the majority of the ARS market is comprised of lower-risk securities that are failing auctions because of illiquidity in the market.
The media in general have ignored the riskier types of ARS when discussing possible resolutions to the current crisis. It is important for treasury managers to understand that while certain potential solutions may exist for the less-risky ARS, these solutions may not be applicable to the riskier ARS issues.
ARS are financial instruments designed to provide a way to finance long-term obligations at short-term interest rates. Through an auction process, interest rates adjust at predetermined periods—typically every seven, 28 or 35 days—with the frequent interest rate resets giving the security a risk-profile similar to a shorter-term security. ARS are typically structured with a maximum interest rate that protects issuers by prohibiting auctions that would result in a rate higher than a specified level. Due to the current credit market environment and the lack of liquidity, many ARS issues have been “failing.” It is important to note that an auction failure does not necessarily denote a default in the security, but is merely indicative of a liquidity issue.
Although the current spotlight is on lower-risk ARS structures, higher-risk structures exist and in certain cases represent a high concentration of a company’s shortterm investments. Although these structures only encompass a small fragment of the overall ARS market, they are important to understand. Some of the most complex ARS were issued as part of consolidated debt obligations (CDOs). For example, Lakeside CDO I, Ltd. issued its most senior tranche in the form of an ARS. These CDO structures typically made investments that included tranches in other CDO (“CDO2”), making them highly nontransparent. Additionally, credit issues have surfaced in these securities due to investments in sub-prime MBS and ABS.
Another high-risk structure known as the contingent capital structure involves monoline bond guarantors. An auction rate preferred is issued by a trust with the proceeds invested in high grade collateral. However, to generate additional income the trust grants a put right to a monocline bond guarantor which allows for the issuance of the monocline’s preferred stock in exchange for the trust’s assets. Thus, this structure exposes the holder directly to creditworthiness of the involved monoline. The various series of Grand Central Capital Trust, a notorious issue within this group, granted Financial Guaranty Insurance Company the right to issue its preferred stock to the trust in exchange for the trusts assets. Given FGIC’s current dire financial position, it now seems that the once unimaginable is now more likely than not.
Another class of high-risk ARS were issued by credit derivative product companies (CDPCs). CDPCs are operating companies that sell protection via credit derivatives. CDPCs are similar in concept to monolines, however unlike monolines they are not regulated as insurers and take on risk using derivative contracts rather than insurance policies. Many CDPCs, such as Athilon Capital Corp., issued ARS as part of their capital structure in the same way a corporation typically issues longterm debt.
Another class of ARS involving a high degree of risk centered around credit-linked notes (CLNs). CLNs are created through a Special Purpose Company [SPC], or trust. These trusts issued ARS and used the proceeds to purchase AAA securities. These AAA securities were used as collateral to enter certain credit derivative swap contracts [CDS]. For example, certain series of Pivot Master Trust were invested in a CLN that invested in a AAA-rated note backed by credit card receivables. This note was then used as collateral to enter a CDS whereby the default risk of 125 companies was assumed at specific tranche levels.
Another structure was issued for the benefit of life insurance companies. Regulation XXX stipulates specific levels of capital reserves insurance companies must carry. Oftentimes, the statutory level of capital demanded by Reg. XXX is greater than the economic level of necessary capital determined by actuarial models. In order to finance the difference, the risk of policies is transferred into a captive insurance company via a reinsurance contract and ARS are issued to raise capital. The proceeds are invested, and generally the expected life of the securities is less than the stated maturity, as redemptions are made as policies are termed or benefits are paid out. Typically, issues of this ARS structure were insurance by a monocline bond guarantor.
ARS Market Resolutions
The riskier structures of ARS began failing auctions in the third quarter of 2007, long before the overall market for ARS fell apart. According to Brian Weber, Senior Analyst at Houlihan, “The riskier classes of ARS were the first to start failing auctions and they will be the last to experience successful auctions again, if ever.”
Many holders of safer auction rate securities enjoy significant yields in the present market on their investments. For these safer ARS, yields are significantly higher than straight-bond issues of similar credit. Issuers are being penalized and paying higher rates because of the ARS structure. Therefore, market resolution is foreseeable through either refinancing or successful auctions.
The opposite is true with many of these high-risk ARS. Many of these securities have relatively low maximum interest rates. Thus, issuers of these securities presently enjoy paying yields much lower than yields offered on straight-bond issues of comparable credit. This results in a disincentive for issuers to refinance these issues. There may be exceptions to this general statement. For example, certain incentives exist for counterparties to restructure issues of the CLNs. However, in general there is strong fundamental support for the less-risky ARS, while that support does not exist for the riskier classes of ARS.
Given that the overall focus has primarily been on the less-risky classes of ARS, it skews the market outlook for holders of the more complex ARS. Therefore it is paramount to distinguish between the risk levels involved in various classes of ARS. Discussion of ARS and potential resolutions to the current market disconnections will most likely not be applicable to all classes of ARS.