The Untold Story of the Auction-Rate
Certain ARS May Continue to Fail Auctions Despite Market Support and Reforms
Houlihan Smith & Company
There has been an increased that while certain potential solutions example, Lakeside CDO I, Ltd.
focus by the media on the ongoing may exist for the less-risky ARS, issued its most senior tranche in the
disruption in the auction-rate these solutions may not be form of an ARS. These CDO
security (“ARS”) market. While applicable to the riskier ARS issues. structures typically made
failures in ARS in 2007 were limited investments that included tranches
to certain, higher-risk securities, the Understanding ARS in other CDO (“CDO2”), making
entire market for ARS collapsed in ARS are financial instruments them highly nontransparent.
the first quarter of 2008. designed to provide a way to finance Additionally, credit issues have
Since that time, the spotlight long-term obligations at short-term surfaced in these securities due to
has been predominantly on the interest rates. Through an auction investments in sub-prime MBS and
lower-risk structures of ARS that process, interest rates adjust at ABS.
represent the vast majority of the predetermined periods—typically Another high-risk structure
market. There are three types of every seven, 28 or 35 days—with known as the contingent capital
ARS that fit into this low-risk the frequent interest rate resets structure involves monoline bond
basket: student loan-backed ARS, giving the security a risk-profile guarantors. An auction rate
municipal tax-exempt ARS, and similar to a shorter-term security. preferred is issued by a trust with
issues from closed-end funds. ARS are typically structured the proceeds invested in high grade
These types of issues have a with a maximum interest rate that collateral. However, to generate
lower risk profile because they protects issuers by prohibiting additional income the trust grants a
either have been structured with auctions that would result in a rate put right to a monocline bond
higher levels of collateralization or higher than a specified level. Due to guarantor which allows for the
have sufficient cash flows to the current credit market issuance of the monocline’s
support interest and principal environment and the lack of preferred stock in exchange for the
payments. According to Karl liquidity, many ARS issues have trust’s assets. Thus, this structure
D’Cunha, Senior Managing Director been “failing.” It is important to exposes the holder directly to
at Houlihan Smith & Company, a note that an auction failure does not creditworthiness of the involved
firm that specializes in the valuation necessarily denote a default in the monoline. The various series of
of ARS, “These type of low-risk security, but is merely indicative of a Grand Central Capital Trust, a
ARS are failing auctions because of liquidity issue. notorious issue within this group,
a lack of liquidity in the market, not granted Financial Guaranty
because of deterioration in credit. Higher-Risk ARS Insurance Company the right to
In other words, it’s a liquidity issue Although the current spotlight issue its preferred stock to the trust
versus a credit issue.” This is on lower-risk ARS structures, in exchange for the trusts assets.
highlights an important point: the higher-risk structures exist and in Given FGIC’s current dire financial
majority of the ARS market is certain cases represent a high position, it now seems that the once
comprised of lower-risk securities concentration of a company’s short- unimaginable is now more likely
that are failing auctions because of term investments. Although these than not.
illiquidity in the market. structures only encompass a small Another class of high-risk ARS
The media in general have fragment of the overall ARS market, were issued by credit derivative
ignored the riskier types of ARS they are important to understand. product companies (CDPCs).
when discussing possible resolutions Some of the most complex ARS CDPCs are operating companies
to the current crisis. It is important were issued as part of consolidated that sell protection via credit
for treasury managers to understand debt obligations (CDOs). For derivatives. CDPCs are similar in
concept to monolines, however ARS Market Resolutions most likely not be applicable to all
unlike monolines they are not The riskier structures of ARS classes of ARS.
regulated as insurers and take on began failing auctions in the third
risk using derivative contracts rather quarter of 2007, long before the Brian Weber is a Senior Analyst at
than insurance policies. Many overall market for ARS fell apart. Houlihan Smith & Co. Karl D’Cunha
CDPCs, such as Athilon Capital According to Brian Weber, Senior is a Senior Managing Director with
Corp., issued ARS as part of their Analyst at Houlihan, “The riskier Houlihan Smith & Co. Houlihan Smith
capital structure in the same way a classes of ARS were the first to start & Co. has numerous clients it advises on
corporation typically issues long- failing auctions and they will be the ARS and has performed FAS 157
term debt. last to experience successful valuations on over $4 billion ARS. Mr.
Another class of ARS involving auctions again, if ever.” Weber can be reached at (312) 499-5956
a high degree of risk centered Many holders of safer auction and Mr. D’Cunha can be reached at
around credit-linked notes (CLNs). rate securities enjoy significant (312) 499-5929.
CLNs are created through a Special yields in the present market on their
Purpose Company (SPC), or trust. investments. For these safer ARS,
These trusts issued ARS and used yields are significantly higher than
the proceeds to purchase AAA straight-bond issues of similar
securities. These AAA securities credit. Issuers are being penalized
were used as collateral to enter and paying higher rates because of
certain credit derivative swap the ARS structure. Therefore,
contracts (CDS). For example, market resolution is foreseeable
certain series of Pivot Master Trust through either refinancing or
were invested in a CLN that successful auctions.
invested in a AAA-rated note The opposite is true with many
backed by credit card receivables. of these high-risk ARS. Many of
This note was then used as collateral these securities have relatively low
to enter a CDS whereby the default maximum interest rates. Thus,
risk of 125 companies was assumed issuers of these securities presently
at specific tranche levels. enjoy paying yields much lower than
Another structure was issued yields offered on straight-bond
for the benefit of life insurance issues of comparable credit. This
companies. Regulation XXX results in a disincentive for issuers
stipulates specific levels of capital to refinance these issues.
reserves insurance companies must There may be exceptions to this
carry. Oftentimes, the statutory general statement. For example,
level of capital demanded by Reg. certain incentives exist for
XXX is greater than the economic counterparties to restructure issues
level of necessary capital determined of the CLNs. However, in general
by actuarial models. In order to there is strong fundamental support
finance the difference, the risk of for the less-risky ARS, while that
policies is transferred into a captive support does not exist for the riskier
insurance company via a reinsurance classes of ARS.
contract and ARS are issued to raise Given that the overall focus has
capital. The proceeds are invested, primarily been on the less-risky
and generally the expected life of classes of ARS, it skews the market
the securities is less than the stated outlook for holders of the more
maturity, as redemptions are made complex ARS. Therefore it is
as policies are termed or benefits are paramount to distinguish between
paid out. Typically, issues of this the risk levels involved in various
ARS structure were insurance by a classes of ARS. Discussion of ARS
monocline bond guarantor. and potential resolutions to the
current market disconnections will