Credit crunch takes toll on the ARS market – auction failures rise alarmingly
The adjustable rate securities (ARS) market was another victim of the asset securitization crisis. The ARS market works with an intention of matching the long term needs of securities issuers and the short term need of the investors. It accomplishes this through the Dutch auction process. Generally, ARS issuers are state and local governments, non-profit hospitals, utilities, housing finance agencies and student loan finance authorities and universities. The total ARS market was worth US$330 billion at the end of 2007, with majority ARS comprising of municipal bonds.
ARS market – composition as on 31 December 2007
Since the beginning of the crisis, the reason for the downfall of the ARS market was the declining credit standards of bond insurance companies. As the bond insurance company’s rating fell, it created a “perfect storm” for the ARS market:
- Investor wariness about the issuer’s repayment abilities increased,
- General investor sentiment soured and risk aversion ran rampant,
- The broker/dealers who historically served as both market makers and buyers of last resort for these securities refused to purchase unsold securities as then have in the past (primarily due to their own financial woes as well as their significant exposure to the monolines as counterparties).
As a result, the proclivity to invest in ARS reduced which led to increased failure of auctions. An auction “fails” if there are not enough buyers to purchase all the securities put out for sale. In such an event, the issuer has to pay the holders the maximum interest rate specified in the official ARS documents. This was a double whammy to the issuer – not getting enough investors plus paying high interest to existing investors. Consequently, the overall cost of funds for these issuers significantly went up. This affected the municipal bond issues and the ARS market as a result, as municipal bonds comprise maximum of the ARS market. To throw salt on the wound, broker/dealers often sold interest rate swaps to municipalities as a hedge, or an income kicker, along with the ARS deals. Many municipalities not only had significantly higher ARS payments, but also witnessed their interest rate swaps turn against them, forcing their payments even higher.
Increased risk in interest rate swap deals
After the securitization crisis ratcheted up mid-2007, banks began to face major problems as lending became riskier and banks were unwilling to lend to each other even at higher interest rate. With credit difficult to obtain, the counterparty risk associated with interest rate swaps began to increase. This led to the well-rated companies also being exposed to counterparty risk.
This is a monthly plot of interest rate on a 10-year US Treasury bill versus the interest rate on a 10-year interest rate swap. The increasing spread from 2006 to 2007 gives us a clear indication that the perception of counterparty risk had risen significantly. The spread between a 10-year treasury bill and an interest rate swap of a similar maturity went up from 47 bps in December 2006 to 66 bps in December 2007, peaking at 74 bps in November 2007, while the average monthly spread from December 2000 – December 2007 was a comparatively lower 54 bps!
10-year interest rate swap, 10-year Treasury bill and the resultant spread
Source: US Federal Reserve
Bankruptcy – this time it is the municipalities
Increasing defaults in the housing market and reduced property values have dampened the outlook of the housing market. In addition, failure of big financial institutions and ratings downgrade of bond insurers have added to the intensity of the crisis. Rising foreclosures and lower property values on revaluation have reduced the local governments’ property taxes. Added to this, counterparty risk has increased from earlier years. All the above factors have led to the municipal bonds being subject to a significantly riskier environment than just a year before—the City of Vallejo, California is in a near bankruptcy state and similar talks are growing about Jefferson County, Alabama and municipalities in Florida.
With the entire state of California negatively affected by the current crisis, the City of Vallejo appears to be the most affected (see Vallejo in danger of declaring bankruptcy). The City of Vallejo, in February 2008, postponed a decision of declaring bankruptcy. Estimates say that currently, the city runs with a deficit of approximately US$10 million today, and is expected to grow over US$13 million at the end of FY 2009.
Jefferson County, on the other hand, took the beating from a failed credit derivative transaction. With the aim of financing a US$3.2 billion sewer cleanup, it resorted to interest-rate swaps with banks which underwrote that debt. The transaction imploded as circumstances in derivative markets deteriorated, leaving the county in a dire situation. See High Finance Backfires on Alabama County.
Future of municipal bonds and its affect on bond insurers
With almost 50% of the total municipal bonds in the US insured by the bond insurers, the downfall in the latter resulted in a significant negative impact on the municipal bond market. Municipal bonds were considered to be safer than most other fixed income securities in the market since they were government-related debt, yet they were also wrapped by monoline insurance contracts. As the ability to bear the liability of a bond declined (at least in the eyes of the capital markets), several bond insurers suffered downgrades by rating companies.
MBIA – Investment portfolio and insured portfolio (as of the end of 1Q 08)
Ambac, the nations 2nd largest and severely distressed bond insurer, reported similar figures to its larger counterpart, MBIA, in 1Q 08. Out of its total financial guarantees, the guarantees for public sector finance constitute 54.2%. In addition, out of its total fixed income investments, 73.2% are in municipal obligations. In the one year period from April 2008 - March 2009, Ambac expects its investment portfolio to generate a cash of US$807 million. This is significantly (and in my opinion, unrealistically) high, especially after Ambac reported negative revenues of US$1.5 million in 1Q 08 and had to exclude BIE’s and include short term security investments born from their recent share offering to quote positive investment income for the quarter.
“Investment income excluding BIEs increased 7.9 million or 7% on increased volume driven by net positive cash flow from operations and to a lesser degree from the capital raise in March, which was primarily invested in short-term securities immediately after the closing. Now, let me focus on the credit issue that arose during the quarter. Our mortgage related exposures continue to drive the poor financial results. We have troubled mortgage exposures in three areas; financial guarantees of RMBS transactions, CDOs of asset backed securities, and to limit extent in our investment agreement, investment portfolio.”
In its 1Q 08 report, MBIA states that out of total insured portfolio of US$668 billion, 60% (or approximately US$438 billion) constitutes US public finance with most of it into GO bonds. Moreover, the company’s investment portfolio consists of approximately 55.5% of investments into the municipal bonds – highest across all categories. Going forward, it expects net investment income to constitute a significant portion of its revenue stream, from 2008 right up to 2017 with its contribution to total revenue increasing in all the years.
I asserted as early as last year that not only will these major mononlines get their lunch handed to them via their residential relate estate related housing exposure, but will also suffer from CMBS related exposure and rising muni distress. Because the level of diversification in this industry is de minimus, any stress in the muni sector will server magnify the horrors they are experience in the structured product and CDS markets.
Ambac – Investment portfolio and insured portfolio (as at end of 1Q 08)
These statistics indicate that in the future, investment income is expected to play a big part in bond insurers’ revenues. However, increasing defaults in the municipal bodies as a result of the ongoing crisis and higher risk in the municipal bond market are likely to significantly affect the performance of the monoline insurers, from both an operating perspective, investment income perspective and a widening of spreads both in their investment portfolio and on their own single name CDS. Also, many state and local governments have entered into credit derivative transactions which, although worked well in the bull phase, are taking a massive toll when the tides have turned.