30 Jun 2008, Peter Madigan, Risk magazine
In its 2008 Liquidity Survey, the Association of Finance Professionals (AFP) found that 69% of surveyed organisations that invested in ARS over the last four years maintain they were given “implied” assurances that dealers would provide support for ARS auctions. A further 17% stated that dealers explicitly promised they would always step in to act as buyer of last resort to maintain liquidity in the market.
The AFP survey also paints a grim picture about the future of the ARS market. Just 18% of responding organisations are now permitted to buy ARS, down from 33% in 2007. The picture is similarly bleak for the related variable-rate demand note (VRDN) market, which has only 17% of firms now permitted to hold the short-term floating rate notes, compared with 25% last year.
The $331 billion ARS market relied heavily upon investment banks to support auctions in the event that no bidder emerged for securities under offer. According to Moody’s Investor Services, between 1984 and 2006 just 13 auctions failed as dealers, acting in their capacity as auction agents, bid on any unsold securities and held them on their own balance sheets until the next auction, typically held at seven-, 14- or 28-day intervals.
January’s ratings downgrades of monoline insurers - which had wrapped the majority of ARS paper in the market - undermined confidence in the sector, reducing private buyer interest and leaving dealers to take up more and more of the slack. Finally, constrained by writedowns they were taking in their mortgage-related structured credit portfolios, and finding funds harder to secure in the jittery liquidity environment, dealers stopped supporting the market altogether in the second week of February.
“A year ago, more than 5% of all short-term investments were made in auction-rate securities. Currently, the average allocation of short-term investments made in ARS has dropped below 1%. This is likely the result of the failures of thousands of auctions that ultimately sapped the liquidity from this investment vehicle,” the AFP report concludes.
Elsewhere, the situation appears to be little improved for the biggest victim of the ARS market collapse, the municipal government of Jefferson County. Alabama, which has an outstanding $3.2 billion exposure to ARS and VRDN paper, overlaid with $5.4 billion in interest rate swaps designed to synthetically fix the variable interest rate papers the county had to make on its sewer debt.
On June 17, a Jefferson County resident filed a lawsuit against the County Commission, the board responsible for the municipality's finances, and JP Morgan, the counterparty for half the interest rate swaps, as well as a range of other institutions, including monoline insurers, broker-dealers and other investment banks, on behalf of all Jefferson residents that have seen utility rates quadruple in the last decade due to compounding interest on the County’s sewer debt.
The County Commission had further incurred the ire of residents in June by announcing that Merrill Lynch would be retained as an adviser on how to alleviate the crippling sewer debt - at a cost of $75,000 a month. The Commission subsequently rejected several of the initial proposals made by Merrill, including setting up an independent oversight committee to manage the county finances and increasing residential utility rates by 2.85% every year. Several Commission members have expressed frustration that Merrill did not propose more innovative solutions.
Jefferson has secured more breathing room to find out a way out of its predicament. On May 30, the county agreed a further forbearance agreement with its swap counterparties, giving the municipality an additional two months to restructure its debt and avoid officially moving into default after failing to meet a $184 million margin call on March 7.
By June 30, however – halfway through the agreed stay – scant progress has been made on establishing a viable means of avoiding what will likely be the biggest municipal bankruptcy in US history.See also:
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