How to Earn 20% in Tax-Free Income

Last summer we were repeatedly told subprime problems would not spread to other markets. "The problems will be contained," proclaimed one authority after another. Now of course we know that this is not the case. The subprime contagion has spread to all sorts of markets far and wide. Small towns in Norway have lost money to subprime borrowers in the US.

The most recent development has been in a rather obscure market called the auction-rate note market. Auction-rate securities are an unusual type of long-term bond that behaves like a short-term bond. While the terms vary, let me quickly try and describe a typical bond, for those who are not familiar with them. A tax-exempt authority like a school district, hospital district, or municipality will issue a long-term bond, but within the covenants of the bond is the stipulation that it will be auctioned every 7 or 30 days. The issuer does this because it allows them to pay a lower overall rate.

Buyers are short-term money market funds and investors who are looking for a slightly higher yield than they can get in a money market fund. These bonds are auctioned by the usual suspects: Lehman, Citigroup, UBS, Merrill, and their kin. In essence, these banks make a market in the bonds.

Let's say a buyer says to UBS, "I will buy Small City School District bonds if they will pay me 4% for the next 30 days." The bonds go to the person who is willing to take the lowest interest rate for any given period. At the end of 30 days, I can re-bid or tell UBS that I want them to take the bonds back. UBS will buy them back from me, and put them on the list to be sold to another bidder the next day.

Why would someone be willing to take a chance on the bonds of a school or hospital district they have no direct knowledge of? Because these various tax-exempt authorities buy insurance from the monoline insurance companies that will give them an investment-grade rating. An investor simply looks at the rating and makes a buy decision.

That was all well and good when you could trust the ratings. Now the creditworthiness of the monoline insurance companies is in serious doubt. Ambac, MBIA, GFIC and others have been downgraded by the rating agencies or are in imminent danger of having their ratings cut.

And without their ratings, they have nothing to sell. A rating cut is essentially a death knell for the company. But it is also a potential crisis for those who have bought the insurance.

And now, these auctions are "failing." By that it is meant that there are not enough buyers to take all the paper. The investment banks are being forced to take back that paper, and they don't want it. Much of the auction market is shut down.

Now, here is the unusual feature of most of these bonds. If for some reason the auction fails, the interest rate is automatically set higher, so that whoever is stuck with the bonds is compensated for the loss of liquidity. And often that rate is a severe blow to the issuer.

Take the Port Authority of New Jersey (PANJ). Their $100,000,000 auction-rate bond offering failed. Their interest rate went from about 4% to 20%! It is costing them an extra $300,000 a week. That is serious money. No one would seriously contend that the PANJ is a financial risk. But buyers simply do not want to take the risk for 4%.

I suspect that the PANJ will quickly put together a $100 million offering and buy back the expensive bonds, but in the meantime they are paying higher rates than they could get from the local Tony Soprano over by the docks.

Good friend and bond maven John Woolway sent me a list of auction-rate bonds. Last week bonds from Puerto Rico, rated AAA, were paying 4.3%. Today the bid is 8.75%, and if the auction fails the rate goes to 12%! The taxpayers of Puerto Rico will have to pay that extra cost. Does anyone seriously think Puerto Rico is not creditworthy? But this is a market that is simply frozen. Buyers are on strike.

There are bonds of many solid issuers that are bidding almost 10% and will reset to 15% if their auctions fail, up from 4-5% last week. Understand, less than 1% of tax-exempt bonds fail. These are good-quality tax-free credits we are talking about, yet the possible interest rate is higher than CCC junk bonds.

The increased cost of interest is a serious blow to some smaller issuers. One hospital district would lose 25% of the operating profits that allow it to purchase new equipment and maintain their facilities. School districts could have to make very ugly choices about where to make cuts in their budgets.

So, what are they doing? They are calling every politician on their rolodexes complaining about the problem. Fix the problem NOW. This week. So, what does Governor Elliot Spitzer of New York do yesterday? He threatens the monoline companies, telling them they have three to five days to find sufficient capital or the state will step in and take charge. And the state does in effect have that authority, as the states are the regulatory authorities.

One concept being floated is to break the monolines up into two banks, a good bank and a bad bank. The good bank would get the very profitable tax-exempt insurance business, and the bad bank would get all the bad subprime and structured vehicle debt. Another is that the monolines raise enough capital to get through the crisis. Some suggest the government step in, as it did with Chrysler.

But the negotiations for additional capital are going rather slowly, or so it seems to those sitting on the outside. (I am sure if you'r on the inside it seems like warp speed.) To get the US government to step in would take even more time. And as I said last week, the spearhead for solving the current credit crisis is fixing the monolines. Nothing is going to get resolved with the current credit crisis until their problems are fixed.