Auction Rate Securities (ARS) and a new Fed ‘Maiden Lane 2’. Also, Cleveland: ‘hold your water.’ And more on fishing weekend in Maine

Author: David Kotok, Post Date: August 10, 2008

The Auction Rate Securities (ARS) market saw big news this week as Merrill Lynch, UBS, and Citigroup settled about $30 billion in claims and agreed to pay investors by buying back their frozen paper over the next several months.  Each settlement has its own time period and terms.

The theme is nearly the same in all of them.  The brokerage firms neither admit nor deny any criminal activities.  The investor gets cash instead of being locked up in these securities that were originally purchased as a cash equivalent.  The problem now transfers to the brokerage firm, which has to dispose of or hold the ARS.  Some firms are forming trusts or other vehicles to hold ARS until they eventually mature.  Others plan to remarket the paper, although there is not a lot of disclosure of the amount of losses that the brokerage firms will take.  Citi estimates a $500 million loss.  So far, Merrill is silent.

Other firms are also silent on their plans.  No matter what, the firms are partially relieved of some potential liability and can begin to get on about their business without this ARS cloud hanging over their heads. 

The ARS investors will face options because the cash will be unfrozen.  Will they put this money into the securities markets?  Will they take out their cash and run elsewhere.  If so, where will they go?  No one knows, and we’ll probably see some of each occur in the future.  The short-term impact is likely to be slightly bullish for other securities like stocks or bonds, since a chunk of the money that was illiquid is now going to be freely available. 

What about the brokerage firms.  First they will recognize the losses, and that will depend on the process they elect to use in absorption of these ARS.  They still face a similar issue with their sophisticated and institutional clients.  They still face some claims and litigation settlements, because it took months to get to this point and some of their customers suffered losses due to the waiting period.  And they still need to raise the cash to pay back the ARS holders.

Some folks speculate that they will look to the Federal Reserve.  This is especially the case for those brokers who are also primary dealers.  That is possible in either a direct way or an indirect way.

Think of it this way.  If a brokerage firm like Merrill uses its access to the Fed, the interest rate attached to the cost of funding the ARS buyback is currently estimated at 2.25%.  Some of this ARS paper might even qualify as collateral, because it is AAA credit quality as to default risk.  It is the illiquidity issue that taints many of these securities, not their credit risk.

Who knows, the Fed might even arrange a Maiden Lane 2 structure for these firms, just like it organized Maiden Lane 1 for the Bear Stearns (BSC) portfolio.  One could argue that the ARS paper is of much higher credit quality than the paper placed in the current Maiden Lane LLC that was specifically formed to hold the BSC paper after the JPMorgan Chase-Bear Stearns deal was forced by the Fed in one of the weekend shootouts.

If the brokerage firms do not use the Fed, the cost will be about 4 times the Fed’s lending rate, and there may be some dilution of existing shareholders if more capital needs to be raised.  We base this estimate on the recent capital raises and the pricing needed by these brokerage firms to attract investors.  More will be revealed as this process unfolds and as Wachovia and Bank of America and others make their settlements.

Meanwhile, there is continued terrific opportunity for investors as long as the detailed homework is done on each security.  A good example is the auction freeze of the Cleveland Ohio water utility.  The original bonds were issued as an AAA insured floater with FGIC insurance.  The liquidity provider has terminated its contract because the rating on FGIC has fallen below investment grade.  At this moment there is no liquidity provider for the auctions and the bonds are in a frozen state.  They are paying an 8% interest rate and that rate is frozen until the situation is fixed or until the bonds mature on January 1, 2033.

Disclosure:  Cumberland Advisors purposefully holds about $8.5 million of these bonds in clients’ accounts.  We are in no hurry to see Cleveland Water fix the problem, although we expect they are busily working on it.  T hese bonds are a natural AA credit.  The water utility is well run.  Cleveland originally got into the floater structure because they believed it would save them money in financing this $90 million.  It did until the financial turmoil derailed the entire Muni market.  Now the water utility is paying 8% while it works out its problem.

8% tax-free on a natural AA credit quality is a gift to a Muni buyer.  It probably won’t last, but it is likely to be there for a period of time until the issue gets resolved.  Just like the recent 9% San Francisco Bay Area Transportation Authority (BATA) bonds, this water utility will have market access and will be able to “bond out” and pay these 8% floaters in full when they do.  Alternatively, they may be able to replace the liquidity provider and restore the auction function; if that happens, the interest rate will probably plummet.  Meanwhile, investors who are opportunistic are taking advantage of this gift that “Mr. Market” has presented to them.  For Cumberland comments on this asset class and on BATA bonds see:

We recommend interested readers also take a few minutes and review Jacqueline Doherty’s excellent article in this week’s Barron’s (page 32) entitled Unlocking the Auction-Rate Mess.”  While in Barron’s, see Jim McTague’s report on the annual fishing retreat weekend, which was featured on CNBC.  For interviews see  We have added that Barron’s article below. 

In Deep Dark Woods, Bears on the Prowl

By JIM MCTAGUE, Barron’s, August 11, 2008 issue, page 33

Bears invade money mavens’ annual fishing outing.

I SHOULD HAVE PACKED A CAN OF PEPPER SPRAY ALONG with my fishing poles this year, because the lodge at Grand Lake Stream, Maine, population 120, was overrun by a herd of frightful bears — more than 30 of them. They left me badly shaken.

For you woodsmen who are grumbling that I am full of blarney because bears by nature are solitary creatures, let me point out that these particular animals wereUrsus wallstreetus horribilis. The sociable predators migrated, as they do annually, from as far west as Victoria, British Columbia, and as far east as London to congregate at remote and lovely Leen’s Lodge to fatten up on smallmouth bass, fine wine, superb Scotch whisky, fat cigars and stimulating conversation in advance of a long, hard winter.

They included big-bank economists, bond traders, money managers and financial consultants who have been brought together in this enchanted world of pristine lakes for almost 10 years by David Kotok, an expert fly fisherman and the chairman and chief investment officer of Cumberland Advisors, a money-management firm in Vineland, N.J. — a short commute to the Atlantic Ocean.

Sure, it was overcast and rainy the entire four days of the gathering. And sure, the fishing wasn’t as spectacular as in the past (I managed just 15 to 20 bass a day, as opposed to 40 or more on other occasions). But that’s not why the crowd was so miserably bearish. There isn’t a mood lamp on earth that would lift spirits laid so low by the seemingly bottomless credit crisis that is now beginning to spread from the housing and financial sectors into other corners of the economy.

Kotok’s diagnosis of the cause of the gloom that permeated the crowd was this: Most of them see more economic downside than upside; we don’t have functioning credit markets; banks and big Wall Street credit intermediaries are either dead, wounded or on life-support; housing is a wreck; and the auto industry "is done."

Once the economy stabilizes, it will take many years to fully recover, he said, because no strong growth engines are evident. "That’s why people are so gloomy! They see no upside!" He personally is investing client money in agricultural plays because, he says, the long-term price of food is trending up. He likes bio-companies whose products are geared to an aging population. And he likes Asia as an investment destination…and he doesn’t like much else.

I conducted in-depth interviews with a dozen of the participants. They all perceive the economy in the early stages of a multiyear recession that will be the most painful downturn since the 1970s. The housing market, which experts once predicted would recover in 2008, may not recover even in 2009. Credit woes on Wall Street will begin to inflict real pain on Main Street.

"The silver lining is that inflation likely peaked in the second quarter and now we will see a deflationary cycle," said Barry Ritholtz, director of equity research for Fusion IQ, a quant shop. Ritholtz says that investors should focus on export-based companies or anything else that will profit from a weaker dollar.

The predictions of the fishing-economics group averaged 2.1% for the federal-funds rate by year end 2008 and 2.5% at midyear 2009; a 10-year Treasury rate of 4.2% at year end ’08 and 4.6% at midyear ’09; the dollar trading at 110 yen at year end ’08 and ¥108.5 at midyear ’09, versus ¥109 now; and the euro trading at $1.48 at year end ’08 and $1.47 at midyear ’09, versus $153.41 now.

Scott Frew, manager of Rockingham Capital Partners, a hedge fund in Connecticut, says that job losses eventually will reach 7% or 8%. He was most bearish because the group, on average, predicted an unemployment rate of 6% for 2008 and 6.1% for 2009. John Silvia, Wachovia’s chief economist, says that unemployment is "widening out" and affecting skilled and highly educated workers. Data show that less than half of all firms intend to add jobs, he says, a sign of slower growth ahead.

AS FOR THE MARKETS, technical analyst Stuart Taylor, a senior fixed-income trader at Eaton Vance, believes that although we have reached a short-term bottom, the overall trend remains down. Maine asset manager J. Dwight sees some attractive prices in the down market, but he’s only nibbling, because he knows they can go down further.

Even the contrarians were depressing.

"I’m certainly not in the world-is-ending camp," said Scotsman Martin Barnes, managing editor of the Bank Credit Analyst. "If you have a nervous disposition, then you can work yourself into a lather about banking problems and various issues." Barnes, who works from his home in Victoria, said that the corporate sector appears to be in decent financial shape, and he thinks that the auto makers are being reasonably aggressive in attacking their problems. Even so, the next few years will be "quite a bit of a slog."

And he adds: "I think we face a mediocre, tough environment — the other side of having this enormous credit boom. And if you believe in symmetry, then the bigger the boom, the bigger the bust!"

I really should have packed some pepper spray.

We thank Barry Ritholtz for forwarding this in a form we can send to our readers.  Barry is quoted along with others from the weekend retreat. 

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