municipalities, student loan providers, and other debt issuers borrowed funds
using auction-rate securities (ARSs), whose interest rates are set
periodically by auctions. ARSs combine features of short- and long-term
securities. ARSs are typically long-maturity bonds with interest rates
linked to short-term money markets. ARS issuance volumes grew rapidly since
they were introduced in the mid-1980s. By 2007, ARSs comprised a $330
billion market. The credit crunch of 2007-2008, however, exposed major
vulnerabilities in the design of ARSs.
Turmoil in global financial markets that erupted in summer 2007, combined with
vulnerabilities in the structure of ARSs, put mounting pressure on the ARS
market. In addition, downgrades of some bond insurers increased stress on
segments of the ARS market. In early February 2008, major ARS dealers
withdrew their support for ARS auctions, most of which then failed. Widespread
auction failures in the ARS market left many investors with illiquid holdings
and sharply increased interest costs for many issuers, such as student
lending agencies, cities, and public authorities. In particular, ARS
failures, according to some, have made it more difficult for student
lenders that had used ARSs to raise funds.
Many major investment banks, in the wake of lawsuits filed by state attorneys
general as well as pressure from state and federal regulators, have
announced plans to repurchase outstanding ARSs for certain relatively
smaller investors and to make efforts to liquidate ARS holdings of larger and institutional
investors. The U.S. Securities and Exchange Commission (SEC) reached several settlements
with broker-dealers in late 2008 and early 2009. Lawsuits alleged that some investment
banks sold ARS products as cash equivalents, but failed to disclose liquidity
risks and the extent of bank support for auctions—the main liquidity
channel for ARSs. Many major investment banks involved in the ARS market
reached settlements and agreements to buy back ARSs from some investors,
typically certain individual investors, non-profit organizations, and small
businesses. Some large firms and high-wealth individuals, however, have not
been covered by these settlements. Some large firms have called for
federal help to sell their ARS holdings.
Some municipal borrowers that used ARSs attempted to hedge interest rate risks
through interest rate swaps linked to LIBOR (London InterBank Offer Rate).
During 2008, however, that type of hedge generally performed poorly. The
City of Baltimore, Maryland has sued banks involved in setting LIBOR
rates, claiming that those rates were kept artificially low. Some parts of the
ARS market, such as municipal issues and closed-end mutual funds, have
restructured much of their debt, as issuers have redeemed ARS securities
and switched to other financing strategies. A much smaller portion of
existing student-loan-backed ARS (SLARS) debt issues have been refinanced.
In the past, Congress has expressed concern about policy areas that the ARS
market’s collapse has affected. For example, the House Financial Services
Committee held a March 2008 hearing to examine how financial market
developments may have increased interest and other financing costs of
state and local governments, followed by another hearing in September 2008 on
ARSs. In April 2008, Congress passed the Ensuring Continued Access to
Student Loans Act of 2008 (H.R. 5715, P.L. 110-227) to allow the Secretary
of Education to provide capital to student lenders, whose ability to
borrow in some cases had been constricted by ARS failures. One proposed Senate
amendment (S.Amdt. 4261) to a supplemental appropriations measure (Disaster
Relief and Summer Jobs Act, H.R. 4899) would let the government buy
certain federally guaranteed loans, which could affect the SLARS market.
Date of Report: July 17, 2012
Number of Pages: 36 Order Number: RL34672 Price: $29.95
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