Auction-Rate Securities Market: Too Good To Last

Local governments across the U.S. are suffering the worst-case scenario of the auction-rate securities market.

Auction-rate securities were supposed to be a cheap alternative to traditional long-term debt by offering financing for 20 years or more at variable rates determined through periodic bidding. The use of auction bonds by states, cities, and municipal borrowers exploded in 2002 but now auction-rate borrowers and taxpayers are suffering as fallout from the collapse of the subprime mortgage market threatens the credit ratings of the world's largest bond insurers, tainting even the safest insured debt. Thousands of auctions have failed from lack of bids, triggering penalty terms that sometimes quadrupled annualized interest rates in one week.

For example, sewer officials for California's Sacramento County sold $250 million of auction-rate securities in November 2004 so they could pay annualized interest as low as 1.35 percent when long- term, fixed-rate bonds were priced to yield an average 4.50 percent. Borrowing for 34 years at a rate that reset every seven days seemed like a good deal until the rate soared to 12 percent last month.

Municipalities that more than tripled auction-rate bond sales between 2001 and 2004 say this year's breakdown in the market showed them why it is not worth being dependant on Wall St. and many are moving towards long-term, fixed-rate debt instead.

For Jefferson County, Alabama, interest on some of the $3.2 billion of auction-rate and other bonds it sold in 2002 and 2003 climbed as high as 10 percent from 2.98 percent in January. They are planning on converting to a fixed-rate debt. If they fail to convert, interest costs may double to more than $250 million annually, which exceeds the $138 million in revenue the sewer system generates yearly.

Even borrowers not facing the excessive interest rates are choosing traditional fixed-rate bonds because locking in costs is safer than having to face the potential soaring rates on auction-rate bonds that typically resets every seven, 28 or 35 days.

Fixed-rate securities made up 83 percent of municipal borrowings in the six weeks beginning Feb. 1, up from 75 percent in all of last year. The auction-rate crisis made it a more attractive option even though yields on 30-year fixed-rate debt reached a three-year high of 5.01 percent March 3.

Examples of others converting to long-term, fixed-rate bonds include:

Rates on $100 million of the auction-rate bonds held by the Port Authority of New York and New Jersey, which owns bridges, tunnels and airports around New York City, soared to 20 percent on Feb. 12. Port Authority sold $700 million of fixed-rate bonds on March 12 to refinance auction securities. One half of the new debt sold at an average interest cost of 5.76 percent, the other half sold at 5.85 percent.

The Port of Portland, which owns the Portland International Airport in Oregon and four marine terminals, is going to refinance $138 million of auction-rate bonds next month after interest rates on some its bonds rose from 3.5 percent to 7.87 percent on Feb. 27. That has added as much as $1 million in additional costs. The port isn't able to directly convert its auction debt into long-term, fixed-rate bonds because the securities are tied to interest-rate swaps. Instead, the district will convert them into another type of variable-rate debt.

Last month, the rates on some of the $430 million in auction-rate bonds the San Francisco Airport Commission sold in 2004 and 2005 were as high as 10.9 percent, up from 4.25 percent in January. The commission is converting $230 million of that debt into fixed- rate bonds because last month alone interest costs increased $2.1 million.