A recent article by David Weinstein in Legal affiliate The New Jersey Law Journal explained that the “subprime mortgage meltdown morphed [into] the municipal bond market” when bond insurance companies’ credit ratings were downgraded. Weinstein noted that “municipalities, schools, colleges and other governmental institutions that borrow to undertake projects” are forced to pay “higher costs for capital improvements” in the wake of revelations that bond insurers had enormous exposure to collateralized debt obligations, or CDOs, and mortgage-backed securities. Weinstein concluded that higher municipal borrowing costs can potentially lead to higher taxes. This column addresses the issues and identifies certain theories being used by public bond issuers to seek recompense for costs caused by their bond insurers.
How Bond Auctions Work
Auction-rate securities, or ARS, and other forms of variable-rate debt instruments are used by municipalities as a low-cost financing tool. Although ARS have intermediate to long-term maturities, they bear interest at lower short-term rates that reset at predetermined intervals; they are bought and sold through a Dutch auction. Typically the auctions reset interest rates every day, seven days, 28 days, 35 days, 49 days or six months. In the auctions, investors submit bids through a broker-dealer acting as auction agent specifying the principal amount to purchase and the minimum interest rate the investor is willing to accept. The auction agent then sorts the bids by their ascending interest rates until the entire principal amount of the securities available for sale are sold. The lowest rate at which all the securities can be sold establishes the “clearing rate” that applies to all the securities of an offering. If there are not enough bids to cover the securities for sale, an auction is said to “fail,” and the rate on the ARS is set at a predetermined “maximum” rate. Nearly $307.2 billion in municipal ARS have been issued since 1988.
Issuers Must Buy Bond Insurance
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