June 25th, 2012

Saber Partners Calls on Municipal Market Regulator to Correct Disclosure on its Auction Rate Securities (ARS) Web Site

An auction mechanism is a key instrument in the capital markets. It has a meaning and that meaning should be supported by precise disclosure. It is important to efficient and effective capital markets that the regulators “get it right.” While municipal ARS may be a nostalgic product, the lessons learned from its rise and fall need to be applied immediately for current investors and future policymakers.

Three areas require Municipal Services Rulemaking Board (MSRB) action regarding information displayed on the MSRB web site.

1. “Bid to Cover” Ratio The amount of demand for available supply. The MSRB “Bid to Cover” ratio for each auction is never defined and suggests to investors that there is more independent investor demand for a particular security at auction than really exists. The MSRB ratio seems to include proprietary bids for the broker-dealer’s account in the auction, which is sometimes for the entire amount of the auction, something a broker-dealer could not do in a US Treasury auction. A key lesson of the auction crisis was that proprietary bids by broker-dealers mask the true liquidity of the investor auction because the broker-dealer has the right to stop bidding at any time it wishes.
2. “NC” or “not calculated” Maximum Rate This is a new term that the MSRB has created on the web site with regard to the maximum permitted rate used when an auction occurs. Unfortunately, it is not a term discussed in auction program documents and may not even be permitted by the terms of the securities themselves. If no rate is calculated, how can investors know what the permitted range of bidding is or after an auction may have failed what the actual yield on their securities is? While the number of instances of this newly created category of “NC” may be small, the volume of occurrences is not a valid exception to the rule of following established auction procedures in disclosure documents and the terms of the securities.
3. Various MSRB market rules governing broker-dealers and short-term securities (that mature under nine months or have investor repurchase rights from the issuer) include references to auction rate securities. These references are confusing at best, misleading at worst. ARS are long-term securities. Maturity is the defined term in finance. It does not require an investor purchasing a security in a secondary market transaction as a “maturity.” MSRB regulations that suggest that a long-term security is in the same category as short-term securities is inappropriate and misleading. See for example: exemption from G-34 for “short-term instruments under nine months in effective maturity, including variable rate instruments, auction rate products, and commercial paper” and elsewhere.

In-Depth Information: Auction Rate Security Transparency Issues in the Municipal Market

How Did the Problem with the MSRB Reporting Errors Begin?

The MSRB changed the EMMA reporting rules for municipal ARS in 2011, after this opaque market virtually collapsed in 2008. At that time, independent investors were demanding significantly higher yields to hold ARS, when investment banks then stopped supporting the periodic auctions by bidding for their own accounts.

For years prior to 2008, bids and purchases by investment banks for ARS had regularly influenced the outcomes and interest rates produced by the auctions. Many auctions only succeeded (i.e., received enough bids to purchase all the securities offered for sale) in that period because investment banks made up for any shortfall in demand from independent investors. But when those banks abruptly stopped bidding in many auctions in February 2008, most independent investors were stranded with illiquid securities at depressed prices. At the same time, many municipal ARS issuers were burdened with excess interest and refinancing costs.

The MSRB’s new ARS transparency reporting requirements were established in 2011, and incorporated many proposals made first by Saber Partners in 2008 and before. (www.saberpartners.com/op-ed/letter-to-the-municipal-securities-rulemaking-board-msrb/ )

“We applaud the MSRB for improving disclosure about the municipal auctions, when other regulators haven’t taken any action for the billions of dollars of corporate auction preferred and other debt securities outstanding,” Fichera said.

Why Is This Important to Market Integrity?

The MSRB was informed as soon as they initiated the new system that the their reported “bid-to-cover” ratio was misleading because it included bids submitted by investment banks for their proprietary accounts, not just by or for independent investors.

Seemingly successful auctions (with more bids than bonds available for sale) could in fact appear this way only because the auctions received voluntary investment bank purchases sufficient to cover any shortfalls in independent market demand. Indeed, many auctions prior to 2008 appeared to have an abundance of bids and bidders, but in reality only the investment banks’ proprietary purchases were driving the pricing. As the 2008 crisis showed, that broker-dealer support could legally be discontinued at any time.

MSRB staff has acknowledged the problem privately and says it is working on it. Yet, the Board has not informed the market that the indicators could be inaccurate or misleading for specific securities.

While it is possible for investors to uncover all the information to construct a more accurate bid-to-cover ratio from the EMMA website, it takes considerable knowledge and effort to glean the relevant data and then calculate it appropriately. Such efforts are unnecessary and prone to error, Fichera said.

“Underwriters, broker-dealers, issuers and investors want government-published market indicators to be accurate, complete and meaningful in all details. The MSRB methodology strays dramatically from how those indicators are commonly understood in other markets, such as for US Treasury auctions,” he added.

How Many Investors Does This Affect?

MSRB and Bloomberg data show almost $40 billion of municipal bonds and another $90 billion of other auction securities are still held in investors’ portfolios. While this is down dramatically from a total of more than $300 billion in 2007, it remains significant. Some market participants hope that the product, first introduced to the municipal market in 1988 by Goldman Sachs, will be “restructured.”

In the meantime, Saber notes that auctions for municipal ARS continue to be conducted every business day for those outstanding securities, almost 5 years after the crisis. Some auctions succeed; most fail. Broker-dealers are bidding for their proprietary accounts again. Some never have stopped.

A Dead Market?

“The history of the auction product has been one of boom-to-bust several times,” Fichera noted. “Each time the market was pronounced dead, a new burst of ‘innovation’ brought it back to life. Regulators should get the principles right now, ahead of the next cycle.”

“Current and future investors both deserve accurate information,” he added. Although new ARS issuances may be unlikely in the near future, the tens of billions of dollars still remaining in investor accounts demand regulatory action to maintain a level playing field and protect market integrity. One clear lesson from the credit crisis should be that complete and accurate market information is vital to protecting all participants – be they underwriters, investors or issuers.

More Problems than Just “Bid-to-Cover” in MSRB Disclosures and Regulations

In addition to the bid-to-cover ratio, Saber called for the MSRB to disclose the maximum rates for auction securities it now lists as “Not Calculated.” Since the auction procedures for each security require the maximum rate to be calculated prior to each auction, it is unclear how such a result could occur and accepted by the MSRB as “normal” and permitted to occur. At a minimum, the system should disclose the formula by which the maximum rate is calculated for all securities (currently, the formulae are only available for a subset of securities).

Finally, Saber urges the MSRB to remove references in its published rules implying that long-term (20-40 years maturities) auction rate securities are actually “short-term securities” with an “effective maturity” of under one year. This does not apply to ARS, as investors who have been forced to hold such securities for almost five years know to their cost. Any such references or ambiguities should be removed.