Auction-Rate Securities: Out of Luck

Holders of these bonds backed by student loans are facing big losses, even as issuers begin discounted buybacks

The auction-rate securities mess is starting to clear up for some investors, but for those who own any of the $85 billion of such debt backed by student loans, the news is bad and getting worse. Sold as rock-solid, highly liquid, cash-equivalent investments, student-loan-backed auction-rate bonds have ended up as one of the worst-performing segments of the market.

In limited secondary market trading, student-loan-backed debt is trading for as little 75¢ on the dollar, a huge loss for investors who were pitched the securities as a higher-yielding alternative to certificates of deposit or money market mutual funds. Analysts expect bids to continue dropping as more holders, particularly public companies, look to sell.

"A lot of people are coming to the realization that there's no light at the end of the tunnel for these," says Cathy Gregg, a partner at corporate finance consulting firm Treasury Strategies in Chicago.

Lack of Buyers Leads to Collapse

The auction-rate securities market (BusinessWeek, 5/22/08) had functioned normally for years, with periodic auctions every 7, 28, or 35 days resetting the interest rates on what were in reality long-term bond issues. Since existing holders believed they could easily sell their securities at auction, they treated the bonds as if they were similar to short-term debt.

But in February, the market collapsed when not enough new buyers showed up at hundreds of auctions. In addition to general concerns arising from the credit market turmoil, investors worried that bond insurers that backed many auction-rate issues were in danger of being downgraded. In the past, the Wall Street firms that conducted the auctions had stepped in and bought to avoid failures. But as they got battered by subprime credit losses, they too stayed on the sidelines.

The key problem for investors holding student-loan-backed debt is that the government-run and private lending authorities that issued the securities have little ability to raise additional funds to redeem their bonds at par. And the so-called penalty rates on many student-loan-backed bonds, the rate that the securities default to in the case of failed auctions, have fallen to 0%, at least temporarily. By law, the trusts that issue student-loan-backed bonds can't pay out more than they receive as interest payments from borrowers.

Small Discounted Buybacks

So far, only one student loan issuer, the Missouri Higher Education Loan Authority, has announced a rescue plan. This issuer has said it will buy back some $30 million of its $3.5 billion of outstanding debt at a discount. A call to the Authority wasn't immediately returned.

About a dozen student loan authorities have either already started quietly buying back small amounts of their auction-rate securities at a discount or are in the planning stages, according to Barry Silbert, president of Restricted Stock Partners in New York. Silbert's firm runs the Restricted Securities Trading Network, which has been one of the only trading outlets for auction-rate securities since the market froze up.

The discounted buybacks by student loan issuers "may be newsworthy but they're so small that they're not going to give a lot of comfort to the holders," Silbert says.

What's Left for Debt-Holders?

By contrast, municipalities have already redeemed or announced plans to redeem more than $60 billion of the $165 billion of auction-rate bonds they issued. Unlike student-loan backed debt, muni auction-rate securities pay high penalty rates, even exceeding 10% in some cases, when their auctions fail.

And closed-end fund issuers are also making progress on redeeming the $60 billion of auction-rate preferred stock shares they backed. Fund issuers have already announced redemptions totaling about 23% of the closed-end fund auction-rate market, according to Wachovia Securities analyst Mariana Bush.

What's left for holders of student-loan-backed debt? There's a limited appetite for purchasing the debt in the secondary market. Much of the money still on the sidelines hopes to buy at 50¢ on the dollar, says Restricted Stock's Silbert. And there's nowhere near $80 billion of possible buyers, he says.

So even with some secondary market sales, investors will be stuck with as much as $70 billion worth of student-loan-backed securities, according to a recent report by JPMorgan analyst Alex Roever. "Current investors are at risk of having to hold positions until maturity, which in a few cases may be almost 40 years away," Roever writes.

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