The Securities Industry and Financial Markets Association (SIFMA) acknowledged that it has "been in discussions with the SEC" over possible means to coax broker-dealers back into the ARS market, following their recent withdrawal from the market that has led to unprecedented numbers of failed auctions in the recent weeks.
The ARS market has provided a means for many municipals, from cities and schools to airports and hospitals, to issue long-term debt securities with short-term interest rate horizons through Dutch auctions held to determine and reset rates on bonds every seven, 28 or 35 days.
Issuers have flocked into ARSs since they were first traded in 1984, due to the low cost of financing long-term obligations by issuing bonds and liquidity levels comparable to those available in the money markets. The market also boasted great stability as dealers acted as buyers of last resort to prevent auction failures and suppress interest rates on the securities.
Following the credit crisis of last year, however, the banks have shied away from their traditional back-stop role as part of a wider aversion to risk exposures and refused to put up their own capital to purchase unwanted securities. This has led to large numbers of failed auctions and higher interest rates for issuers as those investors still willing to take on the debt demand higher interest for their troubles.
In one of the more egregious cases, the Port Authority of New Jersey and New York announced on February 20 that interest on a $100 million debt had jumped from 4.3% to 20% following Goldman Sachs’ refusal to assume the debt. The rate was ultimately set at 8% in accordance with predetermined levels set out in the bond documents.
According to Moody's Investors Service, while there were just 13 failed auctions between 1984 and 2006, 31 auctions failed in the second half of last year and a further 32 failed to end with a successful bid in the first two weeks of January 2008 alone. Data from broker-dealers, still acting in their capacity as auction agents, reported hundreds of ARS auctions failing daily by the last week of February, although they were unable to provide an overall figure.
Market watchers claim that the rising interest rates faced by debt issuers are not only being driven by long-term ARS investors capitalising on the situation, but also by hedge funds that have actively moved into the sector to take full advantage of the high rates available.
Moody's has warned: "Should conditions in the auction rate market not improve, this development could have ratings implications for student loan-backed securitisation in the immediate term and long term for certain public finance issuers."
That warning came just days before the Restricted Securities Trading Network's February 25 announcement that it will commence trading ARSs on March 3, creating a secondary market for the $330 billion asset class, in the hopes of injecting some much-needed liquidity.
Appearing before the US House of Representatives Financial Services Committee on February 27, Federal Reserve chairman Ben Bernanke appeared to downplay the ARS situation, saying: "With respect to municipal bonds and student loans, the good news is that the underlying quality of those credits is generally very good."
"My expectation is that within a relatively short period of time we'll see adjustments in the market to allow municipal borrowers to finance at reasonable interest rates," Bernanke added.