ECNs To The Rescue

Investors stuck with unwanted auction rate securities may soon find a way out.

Independent trading networks are stepping in where Wall Street’s major banks fled, creating secondary markets for trading these securities, once viewed by wealthy individuals and other investors as being as good as cash. Lately, however, they have become about as illiquid as granite.

Trading was set to begin Tuesday at Restricted Stock Partners, a New York-based alternative trading site that specializes in thinly traded securities like warrants and restricted shares. Another site, New York-based the Muni Center, which specializes in municipal bonds, is also getting ready to flick the on switch.

Needless to say, there are a whole bunch of hedge funds and other distressed-securities buyers lined up to pounce. Restricted Stock Partners, which is backed by minority investor Pequot Venture, a unit of Pequot Capital, said it has 60 issues set to trade from a number of sellers and has interest from a variety of buyers.

But the sellers aren’t going to get par value, and possibly not by a long shot. Already, interested buyers not using these trading sites are demanding discounts of 20% to close to 50%, according to Lance Pan, director of investment research at Capital Advisors Group in Newton, Mass. But the new sites can be a way out for investors who need the cash immediately.

That includes not just wealthy individuals but companies that invested in auction rate securities believing they were essentially cash-on-demand securities, Pan said.

The moves come as the finance industry and Washington lawmakers try to shake loose the $330 billion auction rate market, which has frozen up in the credit crunch, leading to significantly higher borrowing costs for major municipal bond issuers like the Port Authority of New York and New Jersey and the Pennsylvania Higher Education Assistance Agency.

Auctions are failing, leaving investors stuck with securities they can’t sell, and issuers looking at far higher interest rates. Port Authority, for example, saw the interest rate of its auction rate bonds soar to 20% from 4% last month after a failed auction. The Pennsylvania Higher Education agency, the second-largest municipal auction rate issuer, said it would stop making student loans after being forced to pay $24 million in extra interest.

Wall Street’s major banks are supporting the concept of a secondary market. Facing their own capital constraints, the major dealers began letting auctions fail last month after refusing to step in and buy in the absence of bidders. Banks, which once supported the auction rate market in this way, face another $30 billion of write-downs in the first quarter after more than $120 billion in the last six months and can no longer afford to extend their balance sheets.

“Near term, the dealers don’t have a solution,” said Pan. They can’t let some investors out at par and make others take a discount, so they abandon everyone.

The Securities Industry and Financial Markets Association, otherwise known as SIFMA, held a conference call with broker-dealers and electronic networks last week to talk about alternatives for solving the crisis, according to some people on the call.

Of course, that doesn’t mean the auction rate market will roar back to life. “The auction rate market is discredited and not likely to make a comeback,” said John Craft, director of business development at the Muni Center, which was founded in 2000 as a site to trade municipal bonds. Merrill Lynch , Morgan Stanley and Citigroup are its original backers.

These securities, invented in 1988, became a popular investment in recent years because they offered investors better short-term yields than other cash-like investments, and issuers, like city treasuries, better borrowing rates.

Auction rate securities are long-term debt, typically municipal bonds or corporate bonds, that act like short-term debt because their interest rates are set every week or so by auction. They are sold in increments of $25,000.

The credit market turmoil has thrown this system into chaos. About half of the $2.4 trillion in municipal bonds outstanding are backed by bond insurance, and the bond insurers are in turmoil after questions about their capital positions and triple-A ratings.

The possibility that one or more of the bond insurers would lose their triple-A credit rating made investors rush to sell their auction rate holdings, but sent any would-be buyers, including the broker-dealers themselves, fleeing from the market.

Last month, 80% of auctions failed. As a result, some $166 billion worth of municipal and corporate debt is being converted to fixed-rate terms, which are more costly for issuers but certainly not as costly as, say, 20% interest. Barry Silbert, chief executive of Restricted Stock Partners, said about 10% to 30% of the $330 billion worth of auction rate securities out there may never trade at par again.

“We’re not going to save the auction rate market,” Silbert said. “But to the extent we can provide liquidity to holders, we’d like to help.”

By Liz Moyer, Forbes Staff

https://www.forbes.com/2008/03/04/bonds-ecns-auctions-biz-wall-cx_lm_0304auctions.html