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Yet More Auction Rate Securities Distress

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The pain and the costs of the dislocation in the auction rate securities market only continues to rise.

In case no one has yet said this clearly enough, this product was a disaster waiting to happen. The idea that one is going to fund long term obligations in a short term funding market is nuts, unless you have a skilled, market savvy treasurer who is prepared to move to longer maturities when you see the short end of the yield curve move against you. And even then, very few respectable pros who were funding long-term operations (as opposed to trading positions) would take the risk of relying heavily on the fickle short-term markets. You’d stagger maturities, extending and shortening maturities if you had the time and patience from time to time. However, in the vast majority of cases, the tried and true, low risk approach is best. Simply match exposures as best you can to the lives of the cash-generating assets (note there is a robust debate as to whether corporate treasuries should be a profit center or not, and if so, how much risk they ought to be permitted to take).

But no one with an operating brain cell should fund a long-lived project or entity on an ongoing basis with short-term debt, particularly one-month-ish debt. You expose yourself to too much uncertainty in your funding costs, as many are learning the hard way now.

From Bloomberg:

New York state taxpayers’ weekly borrowing costs increased $2.3 million after banks failed to attract bidders to auction-rate bonds and stopped buying unwanted securities.

Interest rates on Dormitory Authority bonds sold for the City University of New York rose to as high as 6.26 percent last week from 3.42 percent on Feb. 6, according to data compiled by Bloomberg. Buffalo’s rate on water system revenue bonds soared to 11 percent from 3.30 percent. Bonds issued by the Museum of Modern Art climbed to 4.47 percent on Feb. 13 from 3 percent at the end of January….

“It hurts,” said Anthony Farina, executive assistant in the Buffalo comptroller’s office. Interest costs on the $63 million of auction-rate bonds rose $93,000 for the week, he said. “Nobody expected this kind of jump.”

The Wall Street Journal reports that organizations facing big funding cost increases are quickly trying to raise money at the longer maturities they should have borrowed at in the first place:
Turmoil in an obscure corner of the credit markets is expected to lead to a wave of refinancing by institutions that are in danger of finding themselves paying abnormally high interest rates on their bonds.

One of the first to queue up is the University of Pittsburgh Medical Center, which yesterday announced plans to refinance as much as $430 million of bonds. The medical center offered to buy back $92 million of bonds after market rates on some of its existing auction-rate debt topped 17% last week — threatening the center with extra weekly interest costs of as much as $605,000.

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7 comments

  1. Anonymous

    If municipalities need to raise short term money why can’t they use the Term Auction Facility at the Fed?

  2. Anonymous

    “The idea that one is going to fund long term obligations in a short term funding market is nuts, unless you have a skilled, market savvy treasurer who is prepared to move to longer maturities when you see the short end of the yield curve move against you”

    Except that funding long term liabilities with short term funding is precisely the business of the retail banking industry. If it’s good enough for them, why not our public institutions?

  3. Yves Smith

    Banks are regulated and are required to hold capital because accepting short term deposits and lending long is recognized as a valuable but risky function for the economy. They often get their heads handed to them even though this is their raison d’etre.

    Municipalities get approval from taxpayers (either directly by approving bond issues or indirectly via who they elect) to enter into certain projects deemed useful for the community. They weren’t authorized to speculate with the public’s money, which is what this sort of thing is.

  4. Anonymous

    Yves, Don’t investors in these auction-rate securities make out like bandits as long as there are no defaults? Are investors in those Buffalo water system bonds laughing all the way to the bank (at least if they don’t need the money in the short term)?

  5. Max

    I still don’t understand why the munis went to adopt the AR system, especially at times of flat-to-negative yield curves. I would understand their desire to tap the short end when the long yields were not in their favor, but with treasuries below 5% what was the reason to gamble?

  6. Anonymous

    Wondering how long it will take the issuers of investment grade muni ARS to call them back at par given that they aren’t going to want to continue paying the current high reset rates? I’m currently holding some AAA ARS munis that are insured by FSA, and they are still investment-grade even without the insurance. One of them reset at 10%. How long can I expect this to last before they call the bonds back at par?

    Given the state of the economy, should I be paranoid about potential defaults even if the municipality has a good underlying credit rating? Or is this really a once-in-a-lifetime chance for some high yields with little risk other than that they will likely be called back in the near future at par (and then I would have to settle for measly money market rates instead of 10% tax-free income)?

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