Capital Markets

SEC Blesses Bond Buybacks

Municipalities had feared the regulator's wrath if they tried to repurchase their auction-rate securities.
Sarah JohnsonMarch 12, 2008

The Securities and Exchange Commission will clarify that municipalities can bid on their auction-rate securities (ARS), as long as they provide proper disclosures and aren’t breaking any covenants with bondholders.

That should come as good news to the public-sector financial executives who have seen the securities’ interest rates spike in failed auctions in recent months. For example, one of Mississippi’s securities experienced an 11 percent interest rate for a week after a failed auction, according to state treasurer Tate Reeves. Likewise, Roger Roux, CFO of Rady’s Children’s Hospital in San Diego, saw one of his ARS series fail in auction, resulting in a 15-percent interest rate, he told CFO.com.

One of the more obvious solutions for overcoming the interest hikes is to buy back the bonds. However, previous orders from the SEC directed at securities dealers suggested that bond repurchases by their issuers would be forbidden and reek of market manipulation.

In fact, the municipalities’ fear of overstepping their bounds was “overly conservative” in the opinion of Erik Sirri, director of the SEC’s Division of Trading of Markets. The commission’s staff will issue guidance by the end of the week saying that issuers can indeed buy back their bonds and not be accused of manipulation, Sirri said during Wednesday’s hearing of the House Committee on Financial Services.

In addition to giving the public sector the go-ahead, the SEC’s clarification may “have the secondary effect of easing the substantial financial burden on municipal issuers and conduit borrowers from unusually high interest rates,” Sirri said. The staff will not opine on contract agreements with bondholders that could prevent such buybacks, however — that’s up to the municipalities, schools, and hospitals to address, he added.

The SEC’s scramble to issue guidance has been unusually quick for the regulator. Last month, the commission began receiving letters on the topic from the lawmakers, the Securities Industry and Financial Markets Association, and Ropes & Gray LLP. Ropes’ letter was sent on behalf of 13 hospitals in California and Massachusetts in the hopes that they could they buy back their bonds and 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 partner Anne Phillips Ogilby.

Since 1984, 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.

Roughly half 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 value of the failed ARS auctions are estimated to exceed $80 billion, according to Sirri.

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