$21 Billion Bonds Pulled From Auction-Rate Market

According to Bloomberg, municipal borrowers from Wisconsin to California are escaping soaring costs by pulling at least $21 billion worth of bonds out of the auction-rate market by May 1. This amount is significant because it is more than what was sold in any one year before 2002.

Meanwhile, as the auctions fail, borrowers are switching to fixed-rate bonds and other kinds of variable-rate securities. Based on a Securities Industry and Financial Association index, yields on municipal auction debt are almost double what they were on average in January.

The auction-rate securities market attracted borrowers by offering financing for 20 years or more at variable rates determined through periodic bidding without requiring letters of credit. The use of auction bonds by states, cities and other municipal borrowers exploded in 2002 and sales peaked in 2004 before subsiding in 2007. According to Bloomberg, the $21 billion total represents auction bonds to be called, or bought back, on dates from February through the first of May from an original list of $211 billion of the debt.

From the market's creation in 1984 through 2007, there were less than 50 recorded failures but just this week alone, about 69 percent of auctions failed to attract enough buyers, resulting in interest rates as high as 14 percent. The auction-rate market has been collapsing since Feb. 13 and since then, 60 percent or more of public auctions have been unsuccessful. At failed auctions, the rates borrowers pay revert to a set level of 10 percent or more, or one based upon money-market benchmarks, which have fallen as the Federal Reserve cut interest rates.

Securities with lower failure reset rates, such as closed-end funds' preferred shares and a $250 million deal by Philadelphia, have been failing in greater proportions as investors seek out the better potential returns on bonds with higher penalty rates. Here are some measures being taken to stem the effects of the auction failures:

Philadelphia plans to get final authorization next week to sell fixed-rate bonds in mid-April to replace auction bonds that have been failing.

Wisconsin this week sold about $800 million of bonds to replace some of the state's taxable auction debt that rose in cost to 14 percent this month. Besides fixed-rate bonds, the state also sold securities paying 1.2 percentage points more than the 3.81 percent based on yesterday's rate.

On March 14, the SEC decided to allow nonprofit hospitals and other borrowers to bid on their own auction-rate bonds as an alternative to stemming failures.

The Reading Hospital and Medical Center in Pennsylvania notified investors of plans to bid on March 19 for $40 million of its debt, after having to pay 11 percent after Feb. 13's auction. The winning rate was 3.75 percent, beating out ones that ranged from 5 percent to 11.3 percent.