Auction-Rate Securities And Liquidity

Posted by Bull Bear Trader | 5/26/2008 10:07:00 PM | , , | 0 comments »

As reported in a recent Barron's article, how much money investors get back from auction-rate securities depends on who originally issued the securities. Auction-rate securities are debt that matures in 30 year or more, sometimes in perpetuity. The recent increase in the number sellers compared to buyers has caused some problems in the market, with some issuers running for the door. How the security was initially issued, and for what purpose, may impact how fast you are able to redeem the security.

The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will also likely receive their money, but may have to wait a little longer. Not surprisingly, the investors that purchased auction-rate securities sold by a CDO or student-loan trust will not get their money back for some time, up to many years. Many auction-rate security holders have no idea what the CDOs own since the information is not disclosed. Estimates have about $20 billion of CDO auction-rate securities that are failing to be sold in auction and therefore illiquid. Many of these securities will not be redeemed, and will essentially stay outstanding until the CDO either collapses, or the investment within the CDO mature - in some cases, many years out.

For student loans, many loans are financed by selling them into a trust, and the trust then sells medium and long-term debt, some of which are auction-rate securities. For the trust, there are not many refinancing options given that student-loan financing costs have gone up quickly. Initial rates from some failed auctions were 10% or higher. To prevent problems, some trust have a mechanism that prevents the average rate from going high enough so as to push a trust into default. Some student-loan based auction-rate securities are therefore offering 0% rates to investors, with average rates of 3%. With such low rates, this doesn't encourage student-loan trusts to fix the liquidity problems anytime soon.

Unfortunately, auction-rate securities are probably just one example of what is no doubt becoming a much larger problem. As investment companies continue to deal with their own credit issues, expect more of the fixes, and consequences, to roll down hill.