Out to Save the Auction-Rate Securities Market

by: Gary Smith

Not all is lost in the auction-rate securities market, argues Joe Mysak in Bloomberg today. Admittedly the market has been suffering, with some 70% of auctions in the once-$330 billion market now failing, according to Bloomberg data. When auctions fail, issuers - about half of whom are states and municipalities - pay a penalty rate and the resulting interest has soared to levels far higher than alternative channels.

So the Municipal Securities Rulemaking Board, the self-regulatory organization that covers the municipal market, is attempting to salvage the situation, with plans to improve transparency and daily data collections. At minimum denominations of $25,000 (as opposed to a minimum $100,000 for variable-rate demand obligations), Mysak reports that it is not just "the rich" who buy:

I've heard from self-employed people who thought it was a good, temporary place for their life savings, at least until they decided what else to invest in. I've heard from people who sold businesses and put the money there, and from people who inherited some money and did the same. The amount of money ranges from $50,000 to several million dollars. In each case, the investors say they were advised by their brokers that their money was in a cash equivalent. The investors rarely looked at prospectuses.

The costs to issuers in the auction-rate market led Brazos Higher Education Service Corp., the fourth-largest holder of guaranteed student loans in the U.S., to suspend making new loans, Bloomberg's Michael McDonald reported yesterday.

Brazos Higher Education Service holds more than $15 billion in federally guaranteed student loans, including $7 billion it permanently financed through the sale of auction-rate securities. It is among 26 companies that stopped providing student loans through the Federal Family Education Loan Program according to Finaid.org, a student financial aid publication.

Millions of students may find the cost of loans rising as a result. As Liz Rappaport and Robert Tomsho reported in the Wall Street Journal today:

The void that the lenders leave already accounts for almost 10% of the total estimated loans needed this year, according to one industry estimate.

"I think you will see a larger number of lenders exiting this market," said Sameer Gokhale, an analyst with Keefe, Bruyette & Woods. "They are not making money on these loans."

The Municipal Securities Rulemaking Board may well have its work cut out here.