In the News: Recent Developments

Feb 14, 2008

UBS, Merrill Lynch Step Back From Auction-Rate Bond Bidding

By Martin Z. Braun and William Selway

UBS AG won’t buy auction-rate securities that fail to attract enough bidders and Merrill Lynch & Co. is reducing its purchases, joining a growing number of dealers stepping back from the $300 billion market, according to people with direct knowledge of the matter.

UBS, the second-biggest underwriter of the securities whose rates are reset periodically at auctions, notified its 8,200 U.S. brokers yesterday that it won’t bid on auction-rate securities, while Merrill told its staff it will reduce purchases of the debt, said the people, who declined to be identified because the announcements weren’t publicly disclosed.

Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Citigroup Inc. are also allowing auctions to fail as mounting losses from the collapse of subprime mortgages cause capital markets to seize up.

“We are kind of in uncharted territory right now,” said Anne Kritzmire, a managing director for closed-end funds at Nuveen Investments in Chicago.

As much as $20 billion of auctions didn’t attract enough buyers yesterday, an 80 percent failure rate, based on estimates from Bank of America Corp. and JPMorgan Chase & Co. Banks aren’t obligated to support auctions they run, though they have routinely stepped in to buy debt when bidders couldn’t be found.

Auctions are failing as confidence in the creditworthiness of insurers backing the securities wanes, and as loss-plagued banks seek to avoid tying up their capital. More than 129 auctions failed yesterday, Kritzmire said.

High Rates
Investors don’t lose money when auctions fail and are paid high interest rates in such cases. They may be squeezed by their inability to access their money, however, as the securities were frequently seen as a higher-yielding alternative to certificates of deposits, savings accounts, and other easily accessed investments.

Rohini Pragasam, a spokeswoman for UBS, the second-biggest underwriter of municipal auction-rate debt after Citigroup in 2006 according to Thomson Financial, declined to comment. Michael O’Looney, a spokesman for New York-based Merrill, the third-largest underwriter of the debt in 2006, declined to comment.

Auction bonds have interest rates determined by bidding that typically occurs every seven, 28 or 35 days. When there aren’t enough buyers, the auction fails and bondholders who wanted to sell are left holding the securities. Rates at failed auctions are set at a level spelled out in official statements issued at the initial bond sale.

More Transparency

Investors have little opportunity to judge the risk that auctions will fail because of scant public disclosure about interest rates set at the periodic bidding or other details such as how many bids were submitted or how many bonds were offered for sale.

The Municipal Securities Rulemaking board is working on changes to its trade reporting system that would reveal at least the interest rate on auction bonds when they are traded. Currently, only the price is disclosed.

“I think you need to have more transparency in terms of the market so that investors can judge liquidity risks and so that people, both retail investors and corporate investors, can decide where they want to put their money,” Joseph Fichera, chief executive officer of Saber Partners, a New York based financial adviser to local governments, said in an interview on Bloomberg Television.

Until recently, UBS and other banks that collect fees for running auctions have stepped in with their capital to prevent failures when bidding faltered. These firms have grown unwilling to commit their money to auction-rate securities after suffering at least $133 billion in credit losses and mortgage writedowns stemming from the subprime mortgage collapse.

Bank Losses Mount

UBS today posted the biggest-ever loss by a bank for the fourth quarter.

Merrill last month reported a record loss because of writedowns on assets infected by subprime mortgages. Yesterday, it sent a memo to brokers saying that it would reduce bidding for auction-rate securities “due to current market conditions,” though it may continue to do so “on a selective, case by case basis,” according to a copy obtained from a broker who declined to be identified.

“If you talk to the dealers, their balance sheets are getting flooded with these auction-rate certificates right now,” said Doug Dachille, who oversees $7 billion in fixed-income securities as chief executive officer of First Principles Capital Management LLC in New York. “Right now, the way they’re dealing with the issue is they won’t bid. That’s why we’re seeing failed auctions.”

Three Weeks Ago

Auctions began stumbling three weeks ago when banks couldn’t drum up enough demand for auction rate bonds sold by borrowers, including Georgetown University and Nevada Power. Since then, auctions have failed for frequent and well-known borrowers, such as Port Authority of New York and New Jersey and New York State’s Metropolitan Transportation Authority.

“We’re hearing it’s a general reaction to the auction market,” said Marlene Zurack, senior vice president for New York City’s Health and Hospitals Corp., whose auction yesterday of $64.9 million of bonds failed. “The truth is our credit is good, our ratings are good, our bond insurer is unscathed, and it still happened.”

Massachusetts has sold $565 million in auction-rate securities, including two series of bonds sold in 2000, according to state treasury spokeswoman Alison Mitchell. An auction to reset rates on one of those series failed yesterday, and the rate reset to 4.473 percent from 3 percent, she said.

Wave of Failures

Eighty percent of yesterday’s auctions failed, according to Bank of America. That may mean as much as $20 billion of bonds failed to find buyers, based on the $15 billion to $25 billion of auction-rate bonds scheduled for bidding daily, according to Alex Roever, a JPMorgan Chase & Co. fixed income analyst.

The failures show the widening impact of the bursting of the U.S. housing bubble, which has caused rising defaults on home loans and threatened the credit ratings of the insurance companies that guaranteed structured securities — such as collateralized debt obligations tied to mortgages — against default.

The waning strength of some bond insurers has caused investors to trim holdings of debt backed by companies such as Ambac Financial Group Inc.’s Ambac Assurance Corp., concerned that it may be difficult to sell such debt should insurers’ problems worsen. Today, Moody’s Investors Service removed its Aaa credit rating from FGIC Corp.

The financial straits of the insurance companies hurt borrowers such as the Port Authority, whose auction debt soared to 20 percent on Feb. 12 from 4.3 percent a week ago even though there is little risk of default.

Local governments are obliged to pay the high rates until either the auctions start attracting more buyers or they modify the bonds to some other kind of variable-rate debt or a fixed interest rate. Bankers and borrowers have been working on conversion plans for several weeks.

–With reporting by Henry Goldman, Adam L. Cataldo, Jody Shenn, Jeremy R. Cooke and Carol Massar in New York. Editor: Beth Williams, Gavin Serkin.

To contact the reporter on this story:
Martin Z. Braun in New York at +1-212-617-6849 or;
William Selway in San Francisco at +1-415-743-3511 or

To contact the editor responsible for this story:
Beth Williams at +1-212-617-2307 or

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