The Federal Reserve does not accept auction-rate securities issued by closed-end funds as collateral against loans from its discount window, eliminating a potential source of cash for banks preparing to buy back billions of dollars of these securities.
With little spare capacity on their balance sheets and with funding costs in the capital markets remaining stubbornly high, the Fed’s funding window could be important to plans to buy back the $50bn of auction-rate securities (ARS) required as part of recent deals between banks and regulators to compensate mainly retail investors.
There are three types of ARS: those issued by closed-end funds, called preferred ARS; those issued by municipalities; and those issued by student loan providers.
The preferred ARS are not accepted as collateral for any of the Fed’s lending facilities, according to a Federal Reserve Bank of New York spokesman. Collateral needs to qualify as debt, and these securities are a hybrid of debt and equity.
Starting in September, banks will begin buying back ARS at par from retail investors and small institutional buyers, even though the securities are trading at discounts ranging from 5 to 15 per cent, or more, in a largely illiquid market.
Used for years as a source of cheap funds, the securities were structured as long-term debt, with interest rates set at weekly or monthly auctions to appeal to investors seeking short-term investments.
The $330bn ARS market froze in February after banks refused to back auctions that had failed.
The biggest underwriters of ARS have settled with regulators and agreed to buy back over $50bn of the securities after they were accused of misleading investors by suggesting ARS were as liquid as cash.
Although most banks have said the direct hits of absorbing the losses will be limited, they still need to finance the purchases, especially as the securities may be held on their balance sheets once they have been bought back.
The biggest buyback will be by UBS, which has agreed to repurchase $18.6bn of ARS from institutional and retail investors. UBS plans to develop a trust structure to repurchase $3.5bn of tax-exempt preferred ARS. UBS said the capital and funding impact is manageable.
Merrill Lynch, which agreed to buy back $12bn of ARS from retail investors, said last week the vast majority are closed-end and municipal ARS, but declined to comment further.
Citigroup ($7.3bn of buybacks), Wachovia ($8.8bn), Morgan Stanley ($4.5bn) and JPMorgan ($3bn) declined to comment on financing plans.
Bank of America has estimated there are $38bn of closed-end ARS outstanding. Sold in denominations of $25,000, these are widely held by retail investors. Since February, the overall ARS market has been reduced from $330bn to $206bn.
By Aline van Duyn in New York |
