The Untold Story of ARS

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The Untold Story of ARS Powered By Docstoc
					       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

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Description: There has been an increased focus by the media on the ongoing disruption in the auction-rate security (“ARS”) market. While failures in ARS in 2007 were limited to certain, higher-risk securities, the entire market for ARS collapsed in the first quarter of 2008. Since that time, the spotlight has been predominantly on the lower-risk structures of ARS that represent the vast majority of the market. There are three types of ARS that fit into this low-risk basket: student loan-backed ARS, municipal tax-exempt ARS, and issues from closed-end funds.