Auction Rate Securities: How One Investor Got Out

Posted by guest, Mar 05, 2008 12:32PM

Also, Carney, while you say that you "still haven't been able to get a satisfactory explanation as to us why some auction rate securities were issued with very low penalty rates", you only reinforce your apparent ignorance of credit markets. If the penalty is 150%-200% of the comparable LIBOR/CP rate, that absolutely IS a punitive rate from most issuer's point of view, and in normal circumstances (i.e., isolated auction failure rather than sectorwide liquidity evaporation), this would have served as a powerful incentive to force the issuer to refinance the failed auction paper.

Posted by golden girl, Mar 05, 2008 12:44PM

"guest" is right: don't forget that some of the low reset rates are floating rates that are tied to things like short term LIBOR or commercial paper rates. Since these have plunged, so too have the reset rates.

But you also make a good point - and "guest" is being overly caustic about this -

guest: The point JC is making is that the fail rates weren't even taken into consideration when building and diversifying portfolios! They just "weren't relevant at the time". And of course, now they are just about the ONLY thing that the market is taking into consideration.

Posted by guest, Mar 05, 2008 1:40PM

If that was the point Carney was trying to make, a much more interesting point would have been to examine the inverse relationship between credit quality and liquidity.

Since penalty rates generate liquidity, those auctions tend to be liquid; conversely, the CP/LIBOR rates tend to fail (particularly with CEF PARS), even though in many instances, those assets are the most creditworthy, either because of the underlying instrument, or overcollateralization (in the event of CEF PARS).

This creates a strange dynamic--which is where there is excess demand for the worst assets, and least demand for the best assets. Now in turn factor in two more issues: (1) monolines, and (2) the move to refinance into term loans, and the inevitable steepening that will happen.

Since buyers are flocking to the "worst" assets due to their high penalty rate, that in turn will burn through interest coverage ratios faster--and more of the marginal issuers will tend to approach default. (You saw this, to an extent, in Jefferson County Alabama, this week, for example--although much of that credit problem was admittedly swap related).

In any event, if you buy that penalty rates drive possible default, you end up with an end game where the monolines need to pick up the slack.

Now add in the fact that for the quality issuers like NYC with AA underlying, are going to be quickly terming out their ARS debt--$1.3B announced for this month. The long end of the muni curve has a limited ability to absorb new issues, but the quality issuers will be able to reach the market, even with a steeper curve.

Now back to the low quality credits paying high default interest. Those credits increasingly will be blocked out of the term markets because they can't afford the steeper curve. So I think you'll see them get locked out of refinancing, which in turn will stress the monolines more.

Dont forget that a few years back, a single credit default like the AHERF transaction caused significant losses for MBIA; now you're talking about the possibility of systemic defaults among, say BBB and lower issuers, due to the penalty interest problem. This could easily cascade into more pressure on monolines, even those like FSA or Assured Guaranty.

This would have been a much more interesting story to write, but Carney and DB are too stupid to see it.

Posted by guest, Mar 05, 2008 2:34PM

why would any muni issuer care about rates? They simply raise taxes, tolls etc and if their public objects, well, you simply take from the whiners to pay the interest. If they object more, you send the sheriff with an eviction notice or auction notice and steal, sorry, I mean take, what the muni wants.

I wake every day and say a prayer that some Court takes all this muni paper and shoves it so far up some banks ass, it pops out of their faces. Really, I do pray for that. Or some muni defaults on a billion or two and the court rules, some bank mis-led the muni.

Posted by Anonymous, Mar 05, 2008 2:34PM

Could have done without the last paragraph, but otherwise Comment of the Day.

Posted by guest, Mar 05, 2008 2:56PM

Let's face it--I am an auction rate GOD, and have been shovelling tons of my own money into the sector. Carney should stop trying to swim in the deep end, because he doesnt understand how the market works.

Posted by guest, Mar 05, 2008 3:01PM

tons = hundreds

Posted by guest, Mar 05, 2008 3:06PM

By the way, dont think this is all BS. The Orange County default was about 1/3rd the size of the Alabama sewer problem that is fixing to blow up in FGIC's face.

Posted by guest, Mar 05, 2008 3:07PM

Right, except you mean hundreds ^ 3.

Posted by guest, Mar 05, 2008 3:14PM

And by the way, the monolines if they happen to have wrapped an insured credit, will find themselves between a classic rock and a hard place.

Monolines all the the right, as insurer, to step into the shoes of the issuer and call the debt, which they will do when they think the issue can be "worked out."

But calling the debt will be a massive capital intensive problem for monolines today. AMBAC just raised $1.5B--you think it can afford to call a $400M default from some craptastic revenue bond? Uh, no.

But if the monoline doesn't call the issue, it is stuck with paying penalty rates, which basically magnifies any evenual loss. Most players out there dont understand how much systemic stress could be injected into the system through the ARS mess, if it lasts more than 6 months or so.

Monolines have incredible leverage, more than you can possibly imagine.

Posted by guest, Mar 05, 2008 3:17PM

Sorry, that first sentence should have read: "happen to wrap a failed high penalty credit,..."

Posted by guest, Mar 05, 2008 3:37PM

oh..boo hoo..I mean really? who gives a shit? some insurers and banks took on way too much risk, got caught doing a Senator Craig and now expect sympathy? Fire them and send 'em back to the Iowa cornfields!