For years the auction-rate securities market ran quietly and profitably. But in the past few months, this obscure corner of the bond world has seized up — yet more fallout from the nation's mortgage mess.
Last fall, University of Washington math professor Neal Koblitz and his wife wanted a safe place to park some money for a few months while they hunted for vacation property. A financial consultant at their local Washington Mutual branch suggested a product Koblitz had never heard of before: an “auction-rate securities” account.
The account sounded like a good deal, Koblitz recalled: Not only would it pay higher interest than his existing savings account or a standard money-market account, but the cash would be available on just seven days’ notice.
Auction-rate securities also seemed like the answer for Valley Medical Center in Renton when it needed to raise money for its new seven-story emergency-services tower. Attracted by the cheaper rates — about one and a half percentage points below the rates on standard long-term debt — the hospital sold $170 million in such notes in 2005 and 2006.
“It was a good move at the time we made it, with the information we had at the time,” said Jeannine Grinnell, Valley Medical’s vice president for finance. The hospital saved $2.5 million on interest since 2005.
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For more than 20 years, the auction-rate securities market ran quietly and profitably for thousands of investors and borrowers.
But in the past few months, this obscure corner of the bond world has seized up like an engine without oil — yet more fallout from the nation’s mortgage mess.
With no one willing to buy their securities, many investors’ accounts have been frozen; Koblitz can’t get at his $200,000, though he’s been assured it’s still there.
“Nobody knows when it’s going to be available,” Koblitz said. “I feel like I’m being forced to make a long-term loan at below-market rates.”
And borrowers have seen their once-low rates skyrocket: Valley Medical’s debt shot from 3.75 percent to 15 percent in the space of a week, forcing the hospital to move quickly to refinance.
Wall Street alchemists created auction-rate securities in 1984 to blend some of the most attractive features of long-term and short-term bonds.
The basic idea is pretty simple: Instead of being fixed for 25 or 30 years, the bonds’ interest rate is reset by periodic auctions, which also give investors the chance to buy in or sell out.
The auctions take place every seven, 28 or 35 days, depending on the security; the investment banks that package the securities and run the auctions earn fees for their services.
Auction-rate securities have grown into an estimated $330 billion market. Roughly half that amount is issued by municipalities and quasi-public entities — hospitals, utility districts, colleges and the like.
The rest comes from businesses, including student-loan companies and closed-end mutual funds.
Donna Fincke, executive director of the Washington Health Care Facilities Authority, said that since 2000 her agency has issued $1.9 billion in auction-rate debt on behalf of 11 hospitals and health-care providers in the state — from Children’s Hospital & Regional Medical Center and the Fred Hutchinson Cancer Research Center to Grays Harbor Community Hospital in Aberdeen.
Other auction-rate borrowers in Washington include Energy Northwest, Gonzaga University, the Seattle-based Student Loan Finance Association and the Chelan County Public Utility District.
No buyers, no auction
Auction-rate securities were marketed as safe for both investors and issuers, and until recently few people would have had reason to disagree. Between 1984 and 2006, according to Moody’s, only 13 auctions failed, meaning there were more sellers than buyers.
There was some fine print saying that if an auction failed, investors wouldn’t be able to get their money out until the next successful auction, and borrowers would have to pay a high “penalty rate.”
Historically, however, if an auction seemed about to fail, the investment banks managing it would step in to buy the securities themselves.
But that was before the near-collapse of the U.S. mortgage sector last summer. The mortgage mess has eroded the strength of dozens of financial-services companies — including the big investment banks and the companies that insure bonds against default.
Earlier this year, as several big bond insurers teetered on the brink of insolvency, investors began shying away from the securities they backed. Investment banks, increasingly worried about their own health, started letting auctions fail.
The failure rates peaked in mid-February. Unfortunately for Koblitz, that was just when he wanted to pull his $200,000 out of two auction-rate accounts so he could close on a 43-acre parcel near Deming in Whatcom County.
On Feb. 12, Koblitz told WaMu he’d need the money by the scheduled Feb. 21 closing date, and was assured it would be available. Bank officials repeated that assurance on Feb. 15, after Koblitz read a newspaper article about the rising tide of failed auctions.
But on Feb. 19, WaMu told Koblitz that the auctions for both his accounts had failed, and that his money wouldn’t be available after all. A week later, they failed again. And again the week after that.
“Never in my lifetime — in fact, not since the Great Depression in the 1930s — had customers been unable to rely on an account set up through their local bank,” Koblitz said. (Though he opened the account at WaMu’s University Village branch, it actually was set up through WaMu’s investment division, meaning deposit insurance doesn’t apply.)
Darcy Donahoe-Wilmot, a spokeswoman for WaMu, said about 0.05 percent of its investment clients are invested in auction-rate securities, to the tune of about $50 million. (She wouldn’t give a more precise number, though Koblitz said he was told WaMu had about 2,000 such accounts.) Those like Koblitz whose accounts are effectively frozen have few choices.
“You basically have to wait for the next auction,” she said. “You just have to wait it out.”
But waiting can be expensive, for both investors and borrowers. Grinnell, of Valley Medical, said the jump from 3.75 percent to 15 percent added $320,000 to the hospital’s interest tab. Even after rates fell back a bit, Valley Medical still was paying north of 10 percent.
PeaceHealth, the Bellevue-based health-care system, saw the rate on $43.3 million of debt spike from 3.7 percent Feb. 6 to 15 percent Feb. 13. Four weeks later, it’s still 6.74 percent.
“Our credit rating is AA, we paid the bond insurer to enhance it to AAA — you’d think we’d be insulated over here in our corner of the bond market,” said Roshan Tarikh, system treasury director for PeaceHealth.
Even so, things could be worse: One county in Alabama is contemplating bankruptcy as a result of surging interest costs on its auction-rate debt.
And The Wall Street Journal reported Friday that several Silicon Valley startups that parked their venture-capital cash in auction-rate accounts now can’t get at it to fund their growth plans.
Now paying more
PeaceHealth is weighing several options for refinancing the debt, either to fixed-rate bonds or a different form of variable-rate debt.
But that new variable-rate debt requires a bank letter of credit, and because so many borrowers are seeking such letters at once, Tarikh said, banks are having trouble meeting the demand.
Valley Medical was able to refinance its entire issue of auction-rate debt this past week, Grinnell said, by bundling it into a separate fixed-rate bond issue that was almost ready to go out to market.
But the higher fixed rate, 5.25 percent, will cost Valley Medical about $3 million more a year in interest payments than if the auction-rate debt had stayed around 3.75 percent.
And Koblitz? He and his wife did buy the Whatcom County property, but only by tapping a home-equity line of credit at 6.34 percent interest — considerably more than the 4.7-5.4 percent the money frozen in their auction-rate account is earning.
WaMu and the other banks that sold auction-rate securities, he said, should take the lead in unclogging the market — either by stepping in to buy the securities no one else seems to want or by leaning on the investment banks or the original issuers to do so.
“It would be very harmful to WaMu and other banks if people with savings become mistrustful of all bank accounts,” he said, “and start hoarding money in mattresses or buying gold or doing whatever people do when they lose confidence in the banking system.”
Koblitz owns auction-rate preferred shares, or ARPs, issued by two mutual-fund companies. The rates on those securities, as it happens, are capped at relatively low levels, making it even harder to find buyers for them at auction.
Executives at one of the companies, Van Kampen, said in a teleconference Friday that they’re looking at several options to unstick securities, including refinancing them or converting them to a more liquid form of variable debt.
“We are working diligently and aggressively toward a solution to this problem — a solution that is in the interest of all our (ARP) shareholders,” said Van Kampen managing director Mike Spangler.
But, he added, “There is no timetable at this point for a resolution.”
Drew DeSilver: 206-464-3145 or firstname.lastname@example.org