Despite Impressions, Most Auction Rate Securities Are Healthy

Citigroup (C - commentary - Cramer's Take) has reached a settlement with New York and several other states over auction-rate securities (ARS). In the settlement, the company will purchase approximately $7 billion in ARS which are currently not clearing from individuals, small institutions and charities.

The announcement immediately sent Citi's stock down 4%, and pushed the shares of other major municipal bond dealers sharply lower as well.

There is a key element of this that hasn't been well reported. A very large percentage, something like 80%, of the true "municipal" auction-rate securities have either been refinanced or are actually succeeding at auction.

Most of what's left relates to student-loan financings. In a typical student-loan securitization, a trust is formed which holds the actual loans. The trust then sells securities to the public. This trust is bankruptcy remote from the originator of the student loans.

So if Citigroup arranged your student loan, it probably put it into a trust labeled Student Loan Corporation. The loan is then considered off Citi's balance sheet.

Very few student-loan auction-rate securities (SLARS) have been refinanced. This is because the trust which issued the SLARS has no incentive to refinance. Or more precisely, there is no real decision maker for the trust, at least in terms of their outstanding debt.

In addition, SLARS typically have relatively low maximum coupon rates in the event of an auction failure. Without a tight limit on the rate, it would be possible for the SLARS to carry a higher rate than the underlying student loans.

So now Citi is going to need to find a way to create liquidity in these securities. Unfortunately, with many SLARS, a simple refinancing (even if Citi were willing to somehow subsidize the transaction) may not be possible.

It's also not realistic for Citi to just starting making a market in the ARS and assume liquidity will follow. In other words, the company cannot just go back to their market-making role of years' past. Investors will be once bitten, twice shy this time around.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.