Citigroup Says Auction-Rate Market Will “Cease to Exist”

Citigroup, the top underwriter of auction-rate securities in 2006 with $8.4 billion in sales, says the ailing $330 billion auction-rate securities market will “cease to exist.”

To raise funds, local governments, hospitals, and closed-end mutual funds issued securities maturing in as long as 40 years at interest rates that reset every week to a month through auction bidding. Investors began abandoning the auction-rate market around February this year amid concerns that companies insuring the bonds wouldn’t meet their obligations in case of default. As investment banks and firms suffered write-downs and credit losses, they stopped using their capital to save failed auctions which led to the total collapse of the auction-rate market. Consequently, investors weren’t able to sell their securities and some issuers had to pay hefty penalty interest rates as high as 20 percent.

Citigroup realizes that brokers’ earnings will only be trimmed by 1 to 2 percent by the death of the auction-rate market but investor anger will only rise if there is no solution to liquidate their frozen assets. Investors would also be reluctant to trust brokers and managements firms again.

Some banks are offering help by letting customers borrow against their illiquid auction-rate bonds. UBS AG, which cut the value of the auction-rate securities in its account by about 5 percent, said it would allow customers to borrow the full value of their auction debt from them starting in May. U.S. municipal borrowers have taken this route to refinance their way out of higher costs, and combined with closed-end funds bailing investors out, the auction-rate market has shrunk by $51 billion.

Redemptions will also bail some investors out. Nuveen Investments and seven other fund managers will redeem $7.8 billion in taxable preferred shares that have rates set through periodic dealer-run auctions. About 70 percent of closed-end funds borrow money in an effort to boost returns, most by selling preferred shares on the auction-rate market.

According to Citigroup, the collapse of the auction-rate market will raise the cost of leverage for closed-end funds. It will also benefit firms with large money-market funds such as Federated Investors, BlackRock and Charles Schwab.