The search for yield is providing some much-needed liquidity for a small corner of a market that has yet to recover from the financial crisis: auction rate securities (ARS).
ARS are long-term debt instruments that are resold at regular auctions by banks with the aim of making them act like short-term securities. Until 2008, they were widely marketed, to individuals and corporations alike, as safe yet higher-yielding alternatives to cash. And they largely lived up to this billing, at least until credit markets seized up and Wall Street dealers stopped supporting auctions. That left investors stuck holding some $330 billion of securities that didn't mature for years (or, in the case of preferred stock ARS, never matured).
Over the past four years, the amount of money stranded in ARS has slowly been whittled down, to $77 billion as of May, according to SecondMarket. Banks and brokerages have repurchased much of it from investors in settlements with regulators. And in some cases investors who couldn't wait have turned to SecondMarket and other secondary markets to unload them, often at a steep discount to face value.
Prominent among investors that still have their money locked up are holders of student loan-backed ARS. As of May, there was $38 billion of this paper outstanding. While that's down significantly from $85 billion in February 2008, student loan ARS now account for 45% of the ARS outstanding, up from 25% in February 2008.
Lately, though, things have been looking up. Student loan ARS have been fetching higher prices on SecondMarket. The draw, in addition to yield, is that the underlying student loans are guaranteed by the U.S. government - in some cases, Uncle Sam is on the hook for as much as 98% of the principal.
"Traditional buyers of fixed-income securities, the folks who were buying Fannie Mae and Freddie Mac and some of the mortgage securities and Treasury bills - they are often in search of yield and added return," said Preston Blankenship, vice president of trading at SecondMarket.
Over the past 12 to 18 months, these buyers have begun to bid on the student loan ARS market, Blankenship said. "They are viewing this paper as similar to a 10- to 30-year Treasury bill where there is a coupon on those Treasury securities. he said. "If they can get comfortable with the credit, which is based on the government guarantee and makes it fairly easy for them to do so; they will often come in and bid these securities."
Blakenship said the bid is usually better from this set of buyers, considering the profile of the investors, than say a hedge fund.
Blankenship focuses on facilitating transactions across a number of alternative asset classes, including ARS, ABS, bankruptcy claims, restricted public equity and other esoteric instruments.
The more prices of student loan ARS rise, the more paper is likely to become available, Blankenship said, because it motivates investors, some of whom have been holding onto the securities since the financial crisis, to finally unload them.
"Many ... are willing to sell closer to the 90s versus the 80s as the bid gets closer to the mid-90s, sometimes surpass that, we are going to see more sellers come to the table top find liquidity," he said.
Student loan ARS has some unique features that may limit its appeal, however. ARS backed by both private and government-guaranteed loans may be subject to an available funds cap that limits the amount of interest they can pay out based on the dollar amount of the net interest from the underlying collateral.
Karl D'Cunha, a senior managing director at Madison Street Capital, which tracks the ARS market for clients, said this can make it challenging for investors to manage cash flows.
Right now, investors are at the mercy of the issuer, which today points to the high default rate in the student loan space as the constraint to cash flows in the structure. Even with the government guarantee, there can be a delay between the time of default and the repayment of principal.
The deals are structured in such a way that the issuers are not obligated to deliver the funds on a monthly basis. "Basically, for these structures, the senior pieces are normal senior bonds and by the time those get paid off there isn't enough cashflow left in the pool to pay of the auction rate guys, or at least that is what the issuers have said," D'Cunha said.
Blankenship explained that the interest rate on the bond tends to fluctuate in ARS. An investor can go 11 months without a coupon for student loan ARS, and on the 12th month the coupon pays 12% to 13%, which basically pays for the entire preceding 12 months.
However, one portfolio manager, who spoke on condition of anonymity, said that some of his clients that hold millions of dollars in private student loan paper, have not received a coupon payment since last year.
These buyers will have to wait for the upcoming November elections. A Republican government would potentially bring some changes that would be more favorable for a restructure in the student loan space.
