(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
Auction Rate
Securities Dealers Ask Treasury for Liquidity Facility under EESA
As the financial
crisis deepens, auction rate securities dealers have asked the Treasury to offer
a standby liquidity facility to issuers of such securities, for which the
issuers would pay a commitment fee. The dealers maintain that Treasury has the
authority to do this under the Emergency Economic Stabilization Act. The auction
rate securities market has been frozen for the past eight months, leaving retail
investors with long-term bonds that they couldn't sell.
The dealers group
told Treasury that the market collapsed despite the fact that the credit quality
of most auction rate securities has not deteriorated significantly. According to
the dealers, problems in the auction rate securities market are principally
related to illiquidity, deleveraging and dysfunction in the broader financial
markets, and not to credit deterioration related to these products specifically.
In the letter to
Treasury, the Regional Bond Dealers Association said that the Act authorizes
Treasury to take actions that could significantly improve conditions for auction
rate securities and could help avoid a circumstance where liquidity constrained
banks are forced to buy a large volume of illiquid securities. Specifically, the
association cited Section 101 of the Act, which authorizes Treasury to purchase,
and to make and fund commitments to purchase, troubled assets; and Section 102,
which requires Treasury to establish a program to guarantee troubled assets
originated or issued prior to March 14, 2008.
The dealers group
believes that either of these authorities, but especially the authority provided
in Section 101, allows the establishment of a program under which Treasury would
offer the equivalent of standby bond purchase agreements for variable rate
demand notes issuers whose liquidity facilities are expiring and for auction
rate securities issuers who want to convert their securities to variable rate
demand notes to restore liquidity to investors.
Under the program
proposed by the association, Treasury would offer a standby liquidity facility
to issuers of auction rate securities originally sold before March 14, 2008
secured by whatever assets are currently supporting outstanding auction rate
securities. Issuers would pay a commitment fee, in today's market this fee is
typically 0.45 to 0.55 percent, for the facility.
The issuers would
exchange new variable rate demand notes backed by the liquidity facilities for
outstanding auction rate securities. The association expects that many of the
new demand notes would be eligible for investment by money market mutual funds
subject to regulation under SEC Rule 2a-7. In the view of the dealers, these
actions would open up a new source of demand for issuers whose auction rate
securities are generally not currently eligible for investment by these funds.
The dealers group
believes that safe, stable variable rate securities supported by a Treasury
liquidity facility would appeal to a broad range of investors. It is unlikely
that the facility provided by Treasury would be drawn on to a significant
extent, said the group, because its mere existence would likely provide
confidence to investors and restore normalcy to the market for the affected
products.
If it did buy assets
under the program, Treasury would earn interest at maximum penalty rates that
would likely exceed its own cost of funds and would, in that regard, have a
positive carry. In any case, Treasury would earn revenue from commitment fees.
More broadly, the proposed liquidity would help an orderly market emerge for
hundreds of billions of dollars of assets frozen on the balance sheets of banks,
broker-dealers and investors.
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