• Financial & Investment Management Group
  • Tuesday, January 06, 2009

Opportunity Looms in Time of Crisis

by Suzanne Stepan
Posted May 02, 2008
FIM Group
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It is true. Yet, after having a second look at the title of this article it almost sounds wonderfully greedy, like something Dr. Seuss? The Grinch would think.

There was a time not long ago when many institutional broker dealers underwrote and marketed an auction-rate security (ARS) to customers as a cash equivalent. Cash equivalents refer to accounts that are considered to be ?as safe as? holding cash, earn interest and can be converted into ready money rather quickly. Common examples of cash equivalents include saving deposits, money-market accounts, money-market mutual funds and certificates of deposits.

An ARS is corporate or municipal debt that has a long-term maturity and an interest rate that resets every 7 to 49 days through a Dutch auction. This is a type of auction in which all interested investors submit an interest rate bid to an auction agent for an amount they are prepared to buy based on quality and price. After all the bids are collected, the offering interest rate is determined based on the lowest interest rate for which the total offering can be sold.

The first ARS was launched by Goldman Sachs in 1988. Due to their longevity and the holder?s ability to gain access to their cash in a relatively short period of time, these securities were advertised as a safe cash-like proxy and often sold to high-net-worth individuals and corporations. For many ARS holders, the underlying risks were not fully understood or properly assessed.

Then the worst began to unravel. In early February, ARS investors became nervous and investment banks such as Citigroup, UBS, Morgan Stanley and Merrill Lynch could no longer support bids. By the following week more than eighty percent of the auctions had failed. Conservative, income-oriented investors who thought they could cash out on their holdings discovered that an ARS was not all as liquid as had been expected. This happened after investment banks posted asset write-downs and credit losses and did not have the liquidity to support the auctions. The $330 billion ARS market froze, as the global credit crunch made it progressively difficult for these securities to be liquid and investors lost confidence.

For many ARS holders, it was a case of not reading the fine print, and not fully understanding the risks. They had a false sense of security that holding an ARS was similar to holding cash. Investors realized that they were left holding securities that could not be resold and were losing value by 5 to 25 percent.

The rate of failures reached 87 percent on February 14th, 2008 and has since ranged form 61 percent to 69 percent. From 1984 through 2006, only 13 auctions failed as brokers stepped in to buy bonds when demand was weak.

No longer for confident corporations and high-net-worth individuals, ARSs began being sold to a new subset of interested participants, specifically institutional investors. The collapse of this debt market created a disaster for issuers and trapped bondholders in some lower grade issues with little to no recourse. The words ?auction rate securities? now caused rampant fear.

As investors abandoned the auction-rate market on concerns that the companies who insured the bonds would not be able to meet their obligations in the event of a default, opportunity began to loom across Whoville. It was now possible for investors who performed the appropriate research to earn an annualized 10 percent yield or more on investment grade paper. Last month 29 percent of the auctions were successful. Due to the high levels of induced fear, auction-rate securities were forced to pay holders unbelievable high rates to own the paper.

FIM Group sought out ARSs issued by hospitals that carried a strong underlying credit rating. This particular class of ARSs have never failed at auction, had a secure history of revenue generation and had a unique competitive edge. The underlying securities also required a strong insurance with a predetermined maximum. These are a couple of key elements to understanding the risk and reward behind owning an ARS. Generally the insurance would overlay in the event the issuer could not meet the coupon payments and would pay off the holders of the debt upon default. FIM Group sought out ARSs with a predetermined maximum of at least 12 percent which forces the issuer to have to pay an annualized rate of over 300% to the holder in the event an auction fails.

For many less-educated ARS holders, when the auction failed they were stuck holding securities that did not compensate them for their lack of liquidity. The predetermined maximum is a safeguard that in the event the auction is not successful, the rate shoots up to the maximum and must be paid until the security is fully redeemed.

The best ARS opportunities lasted for about four weeks and have now faded away. There are still some good investments, but harder to find. The excess supply of ARSs was soaked up by the demand created by the new subset of interested institutional investors. The high yields paid on these types of securities with predetermined maximums have forced the borrowers to either call or buy back their bonds.

While the Grinch?s heart had grown three times in size for those desperate investors who have been left high and dry, my advice is seek out investments with firms that have a proven track record for performing due diligence and fully understand the risks in the products they sell. Keep your worries at bay when investing in markets of today, this very day in May. This Little Suzie Lou Who, who is a shade over twenty-two, keeps a keen eye on seeking out investment opportunities, and safe ones too.

 
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