July 10 (Bloomberg) -- Five months after the collapse of the $330 billion auction-rate securities market, bonds backed by student loans show no signs of recovering, and that means no new house for Martin Doolan.

The former corporate turnaround executive delayed buying a new home in Dallas because he can't access the $4.85 million he has in student loan auction-rate bonds without selling them at a loss of at least 20 percent. Doolan said he bought the securities over the last two years through UBS AG because they were billed as easy to turn into cash, like money-market funds.

``I was advised these were the safest'' of all the auction- rate securities, said Doolan, 68, who declined to identify his financial adviser at Zurich-based UBS. ``These are the worst.''

The $85 billion of auction-rate securities sold by state agencies and private lenders to finance student loans are emerging as the most toxic since Wall Street dealers abandoned the market in February amid slumping demand and worries that the bond insurers who guaranteed the debt would be downgraded.

The auctions held every seven, 28 or 35 days to set interest rates on the student loan securities fail about 99 percent of the time, leaving investors such as individuals and corporate cash managers with no choice but to take discounts in secondary markets to get out of the bonds.

Corporate Writedowns

Companies that hold student-loan auction-rate securities wrote down the value of the debt this year, some by as much as 35 percent, according to a survey by Pluris Valuation Advisors LLC. Aventine Renewable Energy Holdings Inc., an ethanol producer based in Pekin, Illinois, said June 13 that it sold $127.2 million of the securities for $97.1 million, representing a 24 percent loss on its investment.

More than two-thirds of the publicly traded companies tracked by Pluris marked down the debt, compared with half that took a loss on their municipal auction-rate debt or securities sold by closed-end funds.

Less than $3 billion of the securities have been refinanced, compared with more than half of the $166 billion sold by municipalities, and 30 percent issued by closed-end mutual funds, according to data compiled by Bloomberg News.

``The entire issue is one of lack of liquidity, and the very poor returns,'' said Espen Robak, president of Pluris, a New York-based firm that helps companies value their holdings.

Rate Caps

Auction-rate bonds, invented about two decades ago, allowed local governments, hospitals and universities to borrow money for the long term at cheaper, short-term rates by reselling the debt at periodic auctions.

Until mid-February, banks supported prices by bidding for bonds that went unsold. Once the banks stopped buying, interest costs soared as high as 20 percent because the failed auctions triggered a penalty rate for issuers.

Rates on student loan securities initially rose, too, climbing as high as 16.58 percent on a Utah State Board of Regents bond on March 5. Interest subsequently fell because the bonds contain provisions that prevent rates from rising for an extended period of time.

That's because the solvency of the lenders is dependent on their ability to borrow at lower rates than those at which they lend. More than half the student loan securities contain these provisions, according to Moody's Investors Service, resulting in interest on at least $8.6 billion of the debt falling to 0 percent as the auction failures persisted, Bloomberg data show.

``That made them, needless to say, totally unattractive to other investors,'' said David Hartung, a structured finance analyst in New York at Dominion Bond Rating Service Ltd.

More Expensive

The collapse of the auction-rate market compounded the financial problems for lenders after Congress last year cut the subsidies it makes to those who sell bonds backed by federally guaranteed loans. More than 100 lenders either curtailed or ceased making federally guaranteed loans this year, forcing lawmakers to intervene by expanding its direct lending program, according to data from FinAid.org, a Web site about student loans based in Cranberry Township, Pennsylvania.

Student loan company Brazos Group Inc. of Waco, Texas, is the largest municipal borrower in the auction-rate market, selling $7 billion of the bonds through the Brazos Higher Education Authority and Brazos Student Finance Corp.

Brazos stopped making loans in March and fired 163 employees in February. At least 3,722 workers in the student loan industry lost jobs this year, according to FinAid.

`No Easy Solution'

``There is no easy solution,'' said Andrew Davis, executive director of the Illinois Student Assistance Commission, which has $880 million in auction-rate securities outstanding in the market. ``The alternatives for us in raising new money are significantly more expensive.''

Steven Shafran, a senior adviser to U.S. Treasury Secretary Henry Paulson, said the federal government could help issuers of student loan auction-rate securities refinance their debt. He said Treasury and U.S. Department of Education officials are working on such a plan, an effort that was delayed because their first priority was to ensure that new student loans were available the coming academic year.

``I'd rather see the government facilitate refinancings,'' as opposed to using its power to guarantee the existing student loan auction-rate securities to improve liquidity, said Shafran, a former investment banker at Goldman Sachs Group, who spoke this morning in Washington at an education finance conference. ``That's the direction of our thinking.''

New Mexico Repurchases

The New Mexico Educational Assistance Foundation is among the few issuers to refinance auction-rate debt, retiring $435 million, about half of what it has outstanding. Woody Farber, the foundation's chief executive, said in an interview that banks are now charging as much as 1 percentage point for a letter of credit to guarantee the bonds, which is in some cases more than twice the cost of a year ago. The foundation also had to pledge more collateral to sell the new bonds.

Some issuers are also buying back their bonds at a discount in the secondary market, according to Barry Silbert, chief executive of Restricted Stock Partners in New York, which operates the largest trading system for the securities.

Sallie Mae, the biggest student loan maker, paid the three- month London interbank offered rate plus 170 basis points to borrow in the taxable market in April, compared with a rate at less than Libor 18 months ago, according to Hartung. The company raised funds at Libor plus between 40 and 90 basis points last month, he said. A basis point is 0.01 percentage point.

Student Loan Portfolio

Doolan, semi-retired since 2003, bought 17 different issues of student loan auction-rate securities, sold by state agencies and nonprofit corporations from Vermont to Missouri. The bonds, which mature between 2020 and 2040, paid interest of as much as 5 percent the month before the market collapsed, compared with top-rated municipal money market rates that averaged 2.8 percent in January, according to Bloomberg data.

Doolan said he was told the auction-rate securities were the safest because they were insured by AAA rated units of New York-based Ambac Financial Group Inc. and Armonk, New York-based MBIA Inc., and the student loans underlying the debt were guaranteed by the federal government. Moody's this year cut Ambac Assurance Corp. to Aa3 and MBIA Insurance Corp. to A2, and Standard & Poor's lowered both the ratings to AA.

Doolan listed the bonds for sale in April on Restricted Securities Trading Network, a secondary market, declining an offer of 80 cents on the dollar for $1.6 million of them.

``It's not for a lack of buyers,'' said Silbert, regarding the plight of investors stuck with the securities. ``It comes down to the holders; they are less willing to take discounts of that size.''

`Working With Clients'

Kris Kagel, a spokesman for UBS, said the firm doesn't comment on individual cases, though it is ``working with clients on a case-by-case basis to address their immediate liquidity needs,'' including offering loans.

UBS was the top underwriter of student loan auction rate securities, managing the sale of 253 issues totaling $28.6 billion, ahead of Citigroup Inc., which sold $27 billion of the bonds in the last decade, according to data from Thomson Reuters.

New York Attorney General Andrew Cuomo is investigating 18 banks and brokers that sold the bonds and the Securities and Exchange Commission is also probing the collapse of the market.

``To have worked for 50 years and not be able to access my money is devastating,'' said Doolan, who said he has contacted state securities regulators in Texas as well as lawyers who specialize in securities arbitration. ``I really don't know where to turn.''

To contact the reporter on this story: Michael McDonald in Boston at Mmcdonald10@bloomberg.net.

Last Updated: July 10, 2008 12:30 EDT