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: www.cumber.com.
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 www.CNBC.com. 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.