Our Run In With Auction Rates And What It Taught Me About Markets

Over the past month, my wife and I had a run in with the auction rate security market. We emerged unscathed but there were a few uncomfortable moments and they taught us a few things about markets that we had sort of understood but not at a gut level. There’s nothing quite like a few sleepless nights to teach you lessons you’ll keep for the rest of your life.

It all started almost a year ago, when we parked a significant amount of cash in tax free municipal bonds. The cash is intended to be used to fund a purchase we plan to make later this year. We wanted the money to be totally safe, very liquid, and produce income that we didn’t need to deal with the hassle of calculating and paying estimated taxes on. So with the advice of some experts on tax free bonds, we purchased three auction rate tax free municipal bonds.

For those who don’t know what an auction rate security is, here’s a short explanation. If you want a longer one, click on the link in that last sentence and wikipedia will do its magic for you. Auction rates are generally long term bonds (corporate or muni) that have their interest rate reset every week via an auction. This does two things. First, it allows the borrower (the corporation or municipal government) to pay short term rates on a long term security. And that can be very beneficial to the borrower. It also allows the purchaser of the bond to have much higher liquidity because the auction rate security is re-auctioned every week. So every week, you have the opportunity to say that you want out and you get out. At least in theory.

We’ve owned auction rate munis on and off for almost 10 years so it’s not like we were new to this market. But the amount we parked in auction rates last spring was significantly more than we’d had in auction rates in the past. I understood how they worked, but honestly never paid much attention to the specifics.

One specific provision of auction rates that is really important, but I honestly knew very little about until the past couple months, is the penalty rate (or maximum rate). If a bond auction does not generate enough demand at any time in the life of the bond, it’s reverts to a long term bond and pays a maximum rate of interest.

Until the recent problems in the fixed income market, brought on by the subprime mess, the auctions of these securities didn’t generally fail. There were a ton of buyers in the market and there was plenty of liquidity. But several things happened that have changed the auction rate market, at least temporarily.

First, and most importantly, the issuers of auction rate securities generally get the bonds insured against default in order to improve the credit quality and rating of the bonds. These bond insurers have gotten into trouble in the subprime mess and they are in various stages of financial distress. Without the security blanket of the bond insurer, many of these auction rate municipal bonds look a bit riskier and so the demand for them has gone down.

In addition, there is a general de-risking going on across all of the capital markets with investors opting in favor of really safe investments right now. So that further dampened the demand for the weekly auctions.

Starting late last year, auctions starting failing. And they have continued to fail for most of the first two months of this year. Investors who were sold a "safe and liquid" bond are waking up to find out that they now have a "pretty safe and illiquid" bond. They are also finding that the interest rates they are now getting have gone up.

So when I got a call from the person who manages our bond portfolio about a month ago telling me that "your bonds have not yet failed an auction but you should know that the risk of it happening has gone up", I started paying attention. I did my homework and got a list of the three bonds we owned and drilled down into the details of what they were. I focused on the borrower, the borrower’s credit, the rating, the insurer, and most importantly the penalty rate. All of our three bonds were issued by government managed utilities in NYC (like water and sewer). All were AA rated borrowers and AAA rated by virtue of bond insurance. All were insured by insurers who were in the news. But most importantly, all had penalty rates above 12%, with one at 15%.

We thought long and hard about what to do. We went for a week or two where we watched to see if the bonds would pass the auctions. In every case they did. As we noodled it over, we came to realize that the auction rates we held were really solid securities because of the penalty rate. Even though we needed the money to be liquid later this year, there were investors who would love to own the securities at a maximum/penalty rate of 12-15%. So there were investors coming into this market almost hoping for an auction to fail. That provided the necessary liquidity to the auctions of these specific bonds.

But even though the bonds were solid, the rates they were paying had gone from 3% in the fall of 2007 to over 7% in February. That’s how messed up the auction rate muni market had gotten. We were getting paid over 7% tax free for bonds that were solid. And the borrower, in our case the local government utilities, just saw their interest expenses go way up.

Ultimately, we decided to bail out of the market and now our cash is sitting in a money market fund paying a fraction of what we were getting in the auction rate market. But we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year. And so, along with a lot of other "safety first" money, we left the auction rate muni market last week.

The most interesting class I took at Wharton where I got my MBA was called "speculative markets" and in that class I learned that markets include different classes of investors. There is the safe money, the hedgers, and the speculators. For example, when a company (like YHOO) get a takeover bid and the stock soars, the safe money generally leaves the stock, takes its gain, and the stock trades into the hands of speculators who are now taking the risk that the deal will in fact go through. They are a different kind of investor who is getting paid to take those kinds of risks.

The same thing has happened to the auction rate security market, at least temporarily. The safe money, at least our safe money and I am sure many others’ safe money, is gone from that market. And in its place are speculators who are willing to take the risk of illiquidity and even default (which is very low in the muni market) in return for getting tax free interest rates of 7% to 15% (which are the equivalent of 10-20% taxable).

What was my big takeaway from this whole affair? When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates. When they are priced appropriately, the market works. When they are not, the market doesn’t work. Thankfully the people who helped us construct our auction rate portfolio understood this. Now we do.

#stocks

Comments (Archived):

  1. curmudgeonly troll

    without those crazy hedge funds to take risks, markets would function less well and the world would be a poorer place. BUT…when everybody rushes to take risk for not much incremental return and then gets cold feet, markets get ugly and stupid.if you have money in a tax-free money market fund and might need that cash, now would be a good time to switch to Treasuries.

    1. fredwilson

      that’s where we are.i learned a long time ago that treasuries are the safest place to be if you need liquidity and protection of principalfred

      1. curmudgeonly troll

        the flip-side is, good time to lock in 5% triple-tax-free if you don’t need the cash, in a fund like an NVN.

  2. Tom Kaz.....

    Fred:It’s been a while since we have chatted but feel free to give me a call. As you may remember, short-term cash investments is something I know more than a little about.Tom Kaz….. at Morgan Stanley (switchboard is 212-761-4000 and they can transfer you assuming your remember the balance of my last name…..)

    1. fredwilson

      Of course I remember you tomI’ll call you to catch upFred

      1. RAGZ

        Hey Fred & Tom (you seem to be in cahoots with great responses to all of these comments),I think the only thing missing from Fred’s article discussion about speculative markets is our economy’s high growth dependency, (though I may have just missed it). Think of it like someone borrowing debt. The more taken, the more principle and interest to pay back in the future. Our expected performance is simply too high to continue, like a nervous debtor who knows that the slightest unexpected difficulty, (car accident, getting sick, house repair), threatens bankruptcy. How long can he sustain?I just graduated with my MBA, and have to finance my loans. 80% of BOA’s student, city, and hospital-backed loans failed to sell in auctions. Meaning as much as $20B of $25B of daily bidding. The baby boomer’s children are just now entering college and building debt. Imagine when their huge numbers begin pouring into the workforce, and there are no new jobs created for them. How about their parents, actual Baby Boomers, (you both I am assuming), needing medical attention? Another worrisome rising trend, is men having heart attacks between 40-60, in record numbers. I’ve had this happen to several of my best friend’s fathers, and boy can it be devastating to a family, both emotionally and financially. Throw in random but high impact events like hurricane Katrina, or 911, and you start to get a picture of the very real future risks involved for every business and person in this country that have been ignored by speculative market pricing.These auction-bond securities, secondary mortgage markets, and the other financial tools have been the cause of major growth over the last few years in our country, both business and personal. The trouble is that the growth was not “quality growth”. Think Trader Joe’s produce compared to Whole Foods produce. With Trader Joe’s, you’re saving cash, but you face a 50% risk of ruining the salad. If the meal is a special day with friends or family, should you be taking that risk? Starbucks shares are down 50%. Why? If you’ve been to a Starbucks in Walmart or any travel stop on 95, between Boston and Washington, DC, you’d know that the standard level of service and quality has become awful. That’s because the managers simply can’t get to all their new locations, and some of these locations should not have carried a Starbrucks brand. Why did Sarbucks management ever open 1/2 of these new stores? Certainly they saw the trend earlier than the share price drop. I noticed the sub-standard retail locations 3 or 4 years ago. Some people in Starbucks corporate must have made a decision that they need to grow as much as possible, straying from traditional and methodical expansion checks and balances, because their cost of capital was artificially lowered enough to make the risks acceptable. Is Starbucks that different from certain consumers whose salary should only cover a car and home of “x” status/cost, but decide to buy more expensive “y” status/cost level cars and homes at “x” level prices?Why has our personal and business growth expectations become requirements?Do you know what I think the best hope for our country is? It’s what other people perceive to be the highest risk we face. We have an experiment running for president that is eager to try a new approach: one that is looking to reach a rational and working compromise. -Aziz

        1. bail bondsman

          i com[pletely agree with RAGZ comment “speculative markets is our economy’s high growth dependency…Do you know what I think the best hope for our country is? It’s what other people perceive to be the highest risk we face. We have an experiment running for president that is eager to try a new approach: one that is looking to reach a rational and working compromise.”You said it all RAGZ

  3. WayneMulligan

    Hi Fred,This was a great post – amazing lessons to be learned here.With your permission, could I possibly repost this as an “answer” on TickerHound.com? (with a link back here of course).I think the community would get a lot out of it.-Wayne

    1. fredwilson

      Of courseAll my posts are rebloggable with a linkback and attribution as long as the blog doesn’t engage in porn or hate speechFred

  4. Tom Hughes

    This is, among other things, an interesting story about the development and then erosion of market-accepted standards, in this case bond credit ratings (AAA, AA… etc.) Bond ratings met a need for investors to efficiently distinguish among investments based on their risk to capital (“will I get my money back?” — a fundamental question). As long as investors trusted bond ratings, markets like this could work, but it turns out that bond ratings are themselves confidence-sensitive. Once it became clear that those ratings could be horribly wrong (in residential mortgage-backed securities, among other categories), these other markets started to suffer as well, even though there was no evidence of a problem with those ratings. What other markets are sensitive to confidence in info-intermediaries? Are we trading (this is purely by way of example) on our confidence that Google’s pagerank algorithm is not influenced by advertisers’ spending? Google embeds a conflict of interest similar to the bond rating agencies — Google’s role is to objectively “relevance rate” different web sites, but they are paid by those sites to steer surfers to them via ads; the rating agencies’ role is to “credit rate” bond issuers objectively, but they are paid by those very issuers.None of this is to suggest that Google (or the bond raters, for that matter) have fallen onto the wrong side of these conflicts of interest. What draws my attention is the degree to which modern business and markets are sensitive to these webs of confidence and mutual trust; and how de facto standards (bond ratings, FICO scores, page ranks) can rest upon little-understood assumptions about the behavior of the standard-setters. Is there business opportunity in uncovering those assumptions and making them explicit? Or will that remain the role of non-profit organizations like Consumers Union and Underwriters Laboratories?

    1. Tom Kaz

      Tom:You bring up a point more broadly that we been discussing in the high-grade investment management business for some time. One theory I have is that, as the world has gotten more fast-paced and complex, we have, in ways small and large, ceded some of our responsibilities to others. While this may not support your Google thought, it does apply in the investment world. A decade ago, most investment managers did some amount of credit research that would examine the financials and prospects of individual issuers. Unfortunately, as staffs were reduced, managed assets grew, the markets appeared less risky and zero-net-sum lives, professional investors got a bit lazy. That translated in relying less on homegrown research and more on credit ratings from S&P, Moody’s, Fitch and others. The running presumption beiing that triple-A meant “almost as sound as the US Government”, a quote of a Japanese pension official who was burned by RMBS.So the buyers, lay person and professional, thought less about what they were actually buying than the credit rating it carried. Asset-backed commercial paper issued by SIVs is a perfect example. I am willing to bet more than a few corporate and professional investors never pulled a pool report, never mind doing it regularly. If they had, the amount of sub-prime in these pools would have frosted the nerves of even the most seasoned pro. Yet, even through late Summer, the largest MMFs were still buying Cheyne, Axon, Whistlejacket and all manner of other cleverly named ABCP programs. That the MMF sponsors had to commit several billion to support the $1 NAV of these funds speaks to the costs of the few bps of incremental yield gained with such paper.The laziness factor does not extend to your Google observation. However, I do recall there was a time just prior to the Google IPO where I noted to my wife that the nature of Googles search results changed. I am a heavy user of technology (nerd?) and research to death any purchase I make for anything that requires electricity to make it work. At that point I noted that the top ranked results shifted from blogs, user reports and professional reviews very blatantly to commercial and faux-review sites (you know the ones). I actually got pissed that I had to wade through so much commercial crap to get to useful information. Did Google change the algorithms to accomodate fee-paying sites? I don’t know, but the change was very real.Tom KazFred – Got your emai (eventually). The primary email domain is @morganstanley.com but I received your second attempt. Will reply soon.

      1. fredwilson

        TomI feel honored to have you commenting on this blogIt makes my day!Fred

      2. Tom Hughes

        Tom,I think your experience does stretch from bond ratings to Google. Both of them are about economies of scale — you can search the Web yourself, but Google can do it on your behalf and my behalf, and therefore better. Similarly, Moody’s or S&P can do credit research on public companies for us both, and therefore better. Like you, I saw the bond market slide away from first-party credit research, at least on investment-grade credits. Many investors seemed to ignore the caveat on their own business (“past performance is not a guarantee of future results”) and assumed that historical default rates for highly-rated securities would continue forever. My feeling is that they were seduced into thinking that bond ratings are somehow empirically observable, like air temperature, when in fact ratings are opinions, put forth by fallible individuals.My interest, though, is less in what went wrong with bond ratings (my former industry), more with where else that kind of mis-categorization might occur; or more generally, what sorts of business depend on assumptions of competence and/or objectivity — assumptions that might come under stress. I didn’t have quite the same feeling you did about Google’s search results; I just felt that the advertisers and site operators were rebalancing the scales in the unending arm’s-race. I didn’t think that Google had sold out; but I do think the Web is now so full of promotional content that it has to saturate any search index that aims for comprehensiveness. I recognize, though, that this all rests on assumptions — the assumption that Google is competent enough to index the Web fully and accurately, and the assumption that Google is objective enough to do so without distorting its findings (especially “relevance”) in favor of its customers, the advertisers.

  5. spraycode

    Looks like Move, Inc is experiencing some of the same issues (from their Q4 earnings call, http://seekingalpha.com/art…As of December 31st our cash and short term investments were $175.6 million which includes $130 million of investments in auction rate securities. These are high grade AAA rated student loan federal government backed auction rate securities issued by student loan funding organizations which loans are 97% guaranteed under FELP, the Federal Family Education Loan Program. Historically, these securities have been considered short term investments and were highly liquid as the interest rate reset every 28 days and allowed investors to either roll over their holdings or sell them at par. However as has been reported in the press earlier this month the auctions for auction rate securities backed by student loans failed. The auction rate securities continue to pay interest at LIBOR plus 1.5% and there‚Äôs been no change in the rating of these securities. As a result of the failed auctions these securities are currently not liquid. We may not be able to access these funds until a future auction of these investments is successful or they are redeemed by the issuer or they mature.I wonder how many CFO’s out there are sweating the fact that their no longer as liquid as they had planned to be?

  6. stone

    Yep. his all sounds familiar. Citibank has been awful over the past 2-3 months. They’re literally in a free-fall and trying to sell anything they can to generate revenue without providing any of the warnings around falling principal vs. PAR on muni bonds. It’s a huge scandal waiting to be exposed. I bought some munis last month for $1.02 vs. PAR and a 5.2% yield to maturity. Today: if i wanted to sell this muni the hit to principal is massive. Now selling at 0.78 — a drop of an astounding $0.24 per increment. What’s more baffling is that each time they call me about a bond they tell me to hurry up because they’re going fast, implying major demand. You can’t have it both ways.

    1. Tom Kaz

      spraycode: Move is just one of dozens of companies that are making these disclosures. I use a Google News bot to track “failed auction-rate securities” and there are daily hits. Some are related to the failure of a toxic class of auctions from late Summer, others are the liquidity-driven (or is it illiquidity-driven) failures of the past several weeks. Believe me, this has impacted hundreds of corporate investors and thousands of individuals. We will be reading about his for quite some time.stone: We could argue on whether there is a scandal here or not. More importantly, what did you own that you think is in the tank? Without knowing the details on the bond you bought last month, it is tough to tell what you are saying. Paying 102% for a 5.2% YTM makes no sense as that would suggest a coupon well above 5% and I have not seen paper of that type in some time. And the 0.78 makes no sense unless you are saying that 0.78% is the yield on short-term variable rate munis (VRDN/VRDO). That is where the highest quality paper tax-exempt is trading, a range of 0.60-1.5%. If that is what you are looking at, what are you complaining about. I can sell you some AAA-rated 98% FFELP student loan backed taxable paper right now at 100 paying a “max rate” coupon of 10% until the next successful auction. Interested?Fred: what have you wrought with this post?

      1. fredwilson

        I have wrought a great discussion and hopefully some business for youIf anyone wants tom and his team at Morgan Stanley watching your short term cash oriented investments, shoot me an email and I’ll do an introfred

        1. Tory

          Fred,Excellent blog!First of all, please introduce us to Tom. We are going through exactly what you did and need this money to buy a house. I just finished my MBA and need to move in May. Our FA knew exactly what our timeline was and plans and continued to advise that we should stay in this paper, even when auctions started faling.We have been trusting our FA’s advice, but when he hunts me down on the phone while I’m out of the country at midnight my time to try to explain that theres a chance the autction will fail and he’s trying assuage my concerns, I started to simmer with rage. Just like you described, he said these would be liquid when we needed them….well we need them. He started telling me not to worry, that his firm can offer a line of credit based on this paper. Why in the heck should I have to be paying them interest when they”re already making some $$ on these ARS’s to begin with!! I think they should give me an interest free loan on my $$ so I can buy my house OR cough up my cash since they never told me I would have any trouble with liquidity.Can I tell him to put in a sell rate that is incredibly low at the next reset? Would that get us in the front of the line for getting bought out? What are my best options for getting this $$ out like you did?

  7. bill burnham

    Hi, Fred, I just met with a small public company on Monday that has a pile of auction rate securities a decent chuck of which have failed and are currently paying penalty interest. Apparently this issue is a big deal with auditors right now and public companies are fighting with them over permanent vs. temporary impairments. Temporary impairments can flow through shareholders equity and don’t impact the income statement but permanent impairments flow through the income statement. Given that public tech companies tend to hold relatively large amounts of cash I wouldn’t be surprised to see some significant write downs flowing through some tech company P/Ls this quarter if the accountants win. Audit committee members had better be prepared for some interesting meetings!

  8. j reacher

    “I understood how they worked, but honestly never paid much attention to the specifics.”caveat emptor dudpay attention next timeor deal with someone who does

    1. fredwilson

      I did “deal with someone who does”Read the last line of the postfred

      1. j reacher

        Apparently not.Although in the past they have been “liquid”, there has always been the real possibilitythat they become “illiquid” and should have been sold that way. Then there would have been no surprises. That’s all. He might have understood them, but sounds likeit was determined not to explain it all to you up front, or he was inadequate in his explanationin the beginning.

  9. Patrick

    In your post you mention that your advisor called you about a month ago and you had time to evaluate the situation. That is quite different from much of what I have read on the situation where brokers and investors were shocked by the auction failure….What I am getting at here is the lack of information coming out of the banks and brokers….

  10. DanInCambridge

    Ok, slightly confused even after reading the wikipedia article…If these auctions fail, then the interest rate gets bumped to a max rate which is pretty damn good. Now wouldn’t that new rate attract new buyers as Fred alluded to? what is the problem?

    1. fredwilson

      The max rate is only in effect if the bonds are illiquid. If they pass an auction and are repriced it is at market rateFred

      1. DanInCambridge

        Right, but here is where I am coming from.You bought these ARS’s because of their liquidity and because of their tax exemption. Well the auction fails and you now own these securities that aren’t liquid but are paying a nice rate, which isn’t something you were too worried to begin with so this investment is failing your model. Well I am MR. Investor and I see that you want out, I’ll pay you principal plus a premium(maybe the last rate, or the highest auction rate over the life of the bond, whatever) to hold these high paying tax free bonds. If they pass an auction a month later and the rate gets reset to something lower that means there is a market for them and I, as MR. Investor, can just sell them right back to you or someone like you.I mean, I don’t see the problem with these auctions failing as long as they have a high enough max rate built in to attract new money, and they seem to be very high.

        1. fredwilson

          You are basically correct. But when an auction fails you are left with something that is, at least temporarily, illiquid. There is no market for them at that time. They can be re-auctioned and if they pass that auction, they become liquid again. But when you are sitting with an illiquid asset when you didn’t plan for it to be illiquid, that is not a comfortable place to be.fred

  11. Andrew

    Great post. So if my investment horizon is 10+ years, I could park a decent amount of cash in an auction rate bond and capture 7-15% interest tax-free? Am I correct in assuming the downsides (i.e. risks) are: (1) it’s an illiquid investment; and (2) possible default from the issuer and/or the insurer of the issuer?

    1. fredwilson

      That rate gets reset every week. At some point the market will correct and those rates will go back downFred

      1. Alex

        Great post. Wondering why on earth these securities were recommended to you in the first place. Unless, of course this was viewed as risk capital by your financial advisers. I’ll have to read the post a couple of more times before I can get a better handle. But, from my take, I think it reads as the spread between the bid and offer was widening greatly. What’s paying better these days short term Treasuries or INSTITUTIONAL money market funds? I would opt for the Institutional money market. It may fit your short term goals better. Of course its not so good for the broker because s/he doesn’t get paid a commission.

        1. fredwilson

          Well if you read the end of the post, it was the experience of our financialadvisors in getting us into the right auction rates that made this story endhappilyfred

  12. Brian

    Thanks for your explanation and sharing your experience. I’ve read about this in the news lately but never would have taken the time to fully understand the issue if I didn’t read your post.

  13. Martin Zacarias

    From 10Kwizard.com I found these public companies that describe this situation as well in their current filings. Great Post!Company Name SymbolForm TypeDateFIVE STAR QUALITY CARE INC FVE10-K03/05/2008ADVANCED ANALOGIC TECHNOLOGIES INCAATI10-K03/04/2008IMCLONE SYSTEMS INC IMCL10-K02/29/2008VECTREN UTILITY HOLDINGS INC AVUCL10-K02/28/2008MOVE INC MOVE8-K02/28/2008FIVE STAR QUALITY CARE INC FVE8-K02/26/2008VECTREN CORP VVC10-K02/20/2008ACTIVCARD CORP ACTI10-Q02/11/2008FAMILY DOLLAR STORES INC FDO10-Q01/09/2008SEATTLE GENETICS INC /WA SGEN10-Q11/08/2007

  14. Steven Kane

    I have made hay, wholesale (and almost in my sleep) in these types securities for years and years.The turmoil in the usually staid muni and auction rate markets is disconcerting, but it is also a major buying opportunity for anybody who does not absolutely need short-short term liquidity.From todays Wall St Journal:Muni Market Gets A Lift as Wilbur Ross And Bill Gross Hop InBy GREGORY ZUCKERMAN and LIZ RAPPAPORTMarch 6, 2008; Page C2Investor Wilbur Ross has purchased $1 billion of beaten-down municipal bonds, a sign that some large investors are snapping up these investments after a recent selloff, taking advantage of the woes of a number of hedge funds that have been forced to sell to try to stay afloat.The new buying by Mr. Ross, and by others such as bond titan Pacific Investment Management Co., or Pimco, is a bet that prices are cheap. But it is also a wager that a Democratic candidate might win the presidency and could potentially raise taxes, making tax-free munis especially attractive. The buying spurt has helped the muni market snap back sharply during the past few days. In fact, Mr. Ross is sitting on paper profits of more than $100 million in the three days since he made the purchase, according to estimates.”We did make a pretty large purchase,” says Mr. Ross, who runs WL Ross & Co. LLC, a $10 billion investment firm. “We think it’s an extremely attractive segment of the market, even after the recent rally.”Thanks in part to the buying from Mr. Ross, Pimco and others, the muni market has rallied sharply in just the past few days, by some estimates as much as 10%.

    1. TomKaz

      OK, I have to focus on addressing a RFP for a day and this discussion gets real interesting. Having just caught up, let me toss out a few comments to various ideas or thought presented above.1) Before anyone calls their brokers and offers to take come ARS off their hands because, hee hee, I am a smart buyer and can “pick off” some cheap paper, do your HOMEWORK. This a very complicated and multi-faceted market and every deal is different. To start with, many of the most attractive issue are actually having successful auctions, albeit, at very high rates. For example, we have seen successful auctions with clearing rates with 4 handles (4.x%). What, no 8-10% tax exempt rates? No, with VRDNs in the 0.75-1.5% rates, smart buyers see value in successful auctions at 4-8%. That said, less attractive issuers (Ambac wrapped or single unit health care facilities) continue to fail with penalty rates of 5-15%.2) Read the definition and calculation of the “penalty rate” because some are real simple and some contain more “or”s, “if”s and “the less of”s than one of Fred’s term sheets. Seriously, a number of student-loan backed ARS are resetting at 0-1%, yes, a penalty rate that is one-third of 1-month LIBOR! A discussion of that is beyond the scope of this venue but suffice it to say that it is real and doubly injurous to those who are already holding this paper. Not sure how widespread this type of formulation is within the tax-exempt ARS market where all you high tax rate guys focus, but they are there.3) Anyone that thinks that these failed muni ARS will go on for 20 or 30 years has to learn more about the product. Everyday we are seeing calls and redemption notices on tens if not hundreds of millions of ARS that are being taken out of the market. Either the muni issuers are refi’g longer and calling ARS with the new proceeds or they are converting multi-modal ARS to VRDNs which are 2a-& MMF eligible.4) I am on the buy side and have not brokerage related compensation streams so my investment decision process is pretty neutral. However, ARS are (were?) the highest commission paying short-term (reset, not mty) security available to transaction compensated brokers. As a result, the majority of accounts holding ARS of every type are brokerage accounts, not investment advisory accounts. That is not to say that money managers did not use them as they did, but more for the offered yield than for the higher than t-bill revenue stream. To put it into perspective, ARS paid brokers 3-4x commercial paper, 10-20x “agencies” and 100x+ USTs. At an average payout to a broker of 10-15 bps per annum, they were very lucrative securities. However, their complicated liqudity structure (as we have seen) disqualified ARS from purchase by registered MMFs under Rule 2a-7 of the ICAo1940. VRDNs however, with their put feature and liquidity facility, are MMF eligible. Yes, someone is bound to post an article questioning whether VRDNs are the next “shoe” and I would say no, unless the banking system is on the verge of collapse which is another discussion altogether.5) Lastly, yes, there are and will be accounting “events” revolving around ARS in public companies. I say “events” because there will be disclosures first. As far as I know, the dealer community priced ARS at 100* (“par with an asterisk”) on their 3/31 statements. That is, there was likely an insert in the envelope or web site discussing the lack of liquidity, etc. So, if pricing is at 100, there have been no losses as yet. Move.com was a good example of a decent disclosure. Note, these disclosures are VERY different than the ARS writedowns and impairments taken by Bristol Myers, Lawson, Ciena, Palm, US Air and a number of others. Those arise from failed auctions in the late Summer that were credit events first and foremost due to the ARS being backed by RMBS, CDOs and other toxic stuff. Valuations on that paper is currently 40-70 cents on the dollar.I hope this helps clear up some of the confusion. If you are a potential buyer, research the issues carefully. Pull the OMs and read the max rate details. Do not rely on a broker’s assessment as most of those folks don’t know what they are talking about.Good luck.Tom

      1. Steven Kane

        Caveat emptor. Naturally. And my buy call is on tax-free paper, like Ross and Gross are buying, not on taxable or corporate-backed ARS.As for the changing meaning of a AAA rating, again, sure, caveat emptor.But stick with “general obligation” AAA munis — “general obligation” means that the issuer has the right to tax and raise taxes to guarantee payment. Everybody catch that? Is there any better guarantee on earth? Sure, many of these issuers buy insurance to get that AAA rating (and therefore shave a few basis points off the coupon), but the insurance is applicable only if the “general obligation” guarantee fails.So sure, if you want to be more kosher than kosher, do try to stay away from any tax-exempt entities or governments that you think are at risk of default (the 0.00000001% that is — even in the S&L crisis the default rate was essentially nil outside the parts of orange county where the biggest baddest most rotten S&Ls were focused…

        1. Tim

          Thanks Steve – New to this, just learning, thinking of same tax free paper, such as large utilities or highway, hospital debt, will look ofr “general obligation” and AAA munis. Can you suggest good source for step by step on how to purchase, manage these investments, or broker?

  15. RacerRick

    Many folks have suddenly learned that just because a bond is AAA and insured doesn’t mean it’s AAA and secured.

  16. Alex

    I did read the post and you were looking for “conservation of capital” (short term horizon).Sequence of events (per your post)1) Uncomfortable position2) Sleepless nights3) Your financial advisor’s saved the day4) Bottle of gin (actually, kidding with this one)Long term bonds with short term time horizon?All in all I’m happy it worked out for you. But, stick to putting together term sheets were you control the risk:)

    1. mharmon

      Over the last few months, my Wife and I put about a quarter of our money in Auction Rate Securities at the recommendation of two of our brokers. I called my broker today to ask to sell the securities, and, you know what happened. We were told they cannot be sold because there is no market for them.I am a computer programmer with an accounting degree. What is the feasibility of creating a website to list these securities for sale. I am asking more about the legal issues, and what disclosures must be made. This would be run by nonprofessionals, and only be a listing service. The actual transaction would be done between the buyer and seller, not the website operator.Would anyone be interested in funding such a development?

  17. Travis

    Hello,I guess I’m in the same camp.Back in February, I purchased Pennsylvania State Higher Education Student Loan Muni Bondrated AAA by Fitch for large amount.My question to you is how were you able to bail out.Did you get 100% money back?I would appreciate for your comment if you have time.Sincerely,Investor at large

    1. fredwilson

      I got out of all of them that had high default rates. But I have one with a low default rate that I cannot get out of. That one I will have to wait for redemption which looks like is being forced by the state lawsuits and settlements