Capital Markets

Forbidden Buybacks

Municipalities, hospitals, and universities plead for the right to repurchase their bonds tied up in the failing auction-rate securities market.
Sarah JohnsonMarch 11, 2008

Companies generally repurchase their stock when they want to bolster the share price. CFOs in the public sector, however, don’t have the luxury of buying back securities from their investors when they need a financial boost.

Finance executives at municipalities, hospitals, and universities are hoping regulators will issue guidance to allow them to bid on their own bonds, even temporarily. With the auction-rate securities (ARS) market tanking and the bonds now unsellable, these CFOs are sitting on weighty interest rates that have been rising quickly in recent weeks.

In mid-February, Roger Roux, CFO of Rady Children’s Hospital in San Diego, saw one of his four ARS series fail in auction. Its interest rate soared from 3.2 percent the previous week to 15 percent. In effect, Roux saw his weekly interest payments more than triple in one week’s time, from $150,000 to $535,000, settling to $376,000 this week. “That [fluctuation] doesn’t really make a whole lot of sense,” he told

He’s perplexed by the ARS market in general, and the behavior of investors in not sticking with the investments now that they’re experiencing the higher yields. The investors must either need the immediate cash, or their confidence in the bonds’ underlying credit has dissipated, he suggests. “Unless you need the liquidity, it’s a pretty darn good investment,” Roux says.

For the past two decades, ARS have been considered safe and liquid investments. Indeed, many companies have recorded them as cash equivalents on their balance sheets. Through a Dutch-auction process, the ARS variable interest rates reset at periods of either seven, 28 or 35 days (Rady Children’s rates, for example, reset every seven days).

Credit downgrades of bond insurers have turned investors off from the securities, including the bond dealers that have usually picked up the securities that go unsold at the auctions. The auction failures have hurt some companies, including 3M and US Airways, and forced some, such as Bristol-Myers Squibb, to write down cash.

The effect could hit hardest in the public sector. Roughly half of the estimated $328-billion ARS market is made up of tax-exempt (and some taxable) issues of state and local governments, not-for-profit hospitals, colleges, and universities, according to Moody’s Investors Service.

The failed auctions have these CFOs contemplating whether they have to lay off staff and cut back on programs already at risk from declining tax revenues. In a letter to the Securities and Exchange Commission on behalf of 13 hospitals in California and Massachusetts, Ropes & Gray LLP asked that the firm’s clients be given the ability to buy back their bonds.

The hospitals want clear direction from the SEC that they wouldn’t be violating any of the regulator’s orders and so that they can avoid having “to make potentially wrenching budget cuts that would adversely affect the millions of patients, students, employees, and other individuals served by these major employers,” wrote Ropes partner Anne Phillips Ogilby. For example, one of her clients estimates the salaries of 250 full-time nurses would have to be cut in order to make up for the higher interest rates of the bonds.

The SEC has also received letters about the topic from the Securities Industry and Financial Markets Association and lawmakers. “The unprecedented lack of demand has caused the interest rates on these high-quality securities to spike upwards at a time when state and local governments, hospitals, and universities can least afford the added debt service,” wrote members of the House Committee on Financial Services, which is holding a hearing on municipal bonds on Wednesday. Erik Sirri, director of the SEC’s Division of Trading and Markets and several state treasurers are scheduled to testify.

As for Roux, he’s thinking about getting out of the ARS market altogether, and isn’t sure the SEC will take action soon enough to help his situation. He is going over his options with banks, such as the creation of a credit facility to convert the debt to fixed-rate securities.

Two years ago, his hospital saw the ARS market as an inexpensive financing route. “It provided the lowest cost option,” he says. “We got lower rates than the other approaches, but if that mode is gone, you have to look at your other options.”