Zero Beta

The recent failures amongst Auction Rate Securities has gone very underreported and has caused a strange reaction from many that is a combination of fear, anger, and confusion. This was a reaction I have not seen in the prior “shoes to drop” - CDO’s and SIV’s. While, there is great uncertainty as to what will happen with this market and its bigger implications, it is important to look at it from a Game Theory standpoint and compare it to previous auctions in financial history.

Auction rate securities are long term variable rate bonds that are tied to short term interest rates. Many municipalities issue these securities because it enables them to receive low-cost, long term financing at short term rates. It resets every 7, 28, or 35 days at which investors can choose to hold at market, hold at their rate, or sell. It is also less costly, as it does not require a letter of credit and annual reviews from credit rating agencies. They are usually issued by very high rated municipalities and/or credit enhanced through bond insurance. Investors in these securities are usually conservative high net worth individuals or corporations looking for a tax friendly, liquid investment for their cash. These securities do not have a “put feature”, meaning they do not have the ability to sell the security back to the issuer at a certain price. This makes them very sensitive to credit ratings and usually require the highest rating in order to be marketable and liquid.

Auction rate securities are sold in a Dutch Auction format. In regards to security issuance, a Dutch Auction is a public offering auction structure in which the price of the offering is set after taking in all bids and determining the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price. This type of auction is named for its best known example, the Dutch tulip auctions (more on this later), but more recently it is the format used for Treasury bonds and was used for Google’s IPO.

When applied to auction rate securities, investors submit their bids for yields and prices and then a clearing rate, equal to the lowest bid (highest price) that all the securities can be sold at par. An auction failure occurs when there is not enough buyers or bidders to satisfy the issue. In this case, everyone who owns the security is paid a maximum rate or rate cap. Recent stories of faild Port Authority bond auctions paying 20% illustrate this mechanism.

Auction Theory

Auction theory is an applied branch of game theory which deals with how people act in auction markets and researches the game-theoretic properties of auction markets. There are many possible designs (or sets of rules) for an auction and typical issues studied by auction theorists include the efficiency of a given auction design, optimal and equilibrium bidding strategies, and revenue comparison. Auction theory is also used as a tool to inform the design of real-world auctions; most notably auctions for the privatisation of public-sector companies or the sale of licenses for use of the electromagnetic spectrum.

Dutch auctions in financial markets, such as for auction rate securities, are usually the same as a sealed first-price auction. This is a form of auction where bidders submit one bid in a concealed fashion. The submitted bids are then compared and the person with the highest bid wins the award, and pays the amount of his bid to the seller. In these auctions, bidders must submit their bids based on their own valuation and willingness to pay. In these auctions the lowest bidder wins. This is different than English auctions, where bids are a competition for relative price amongst other bidders.

A key feature of auctions is the existence of asymmetric information. Paul Klemplerer in Auctions: Theory and Practice describes the different models,

In the basic private-value model each bidder knows how much she values the object(s) for sale, but her value is private information to herself.

In the pure common-value model, by contrast, the actual value is the same for everyone, but bidders have different private information about what that value actually is. For example, the value of an oil lease depends on how much oil is under the ground, and bidders may have access to different geological “signals’’ about that amount. In this case a bidder would change her estimate of the value if she learnt another bidder’s signal, in contrast to the private value case in which her value would be unaffected by learning any other bidder’s preferences or information.

A general model encompassing both these as special cases assumes each bidder receives a private information signal, but allows each bidder’s value to be a general function of all the signals. For example, your value for a painting may depend mostly on your own private information (how much you like it) but also somewhat on others’ private information (how much they like it) because this affects the resale value and/or the prestige of owning it.

In the case of auction rate securities, the general model is a good proxy for the auction model.

Many auctions are subject to something called the Winner’s curse. The Winner’s curse is a phenomenon akin to a Pyrrhic victory that occurs in common value auctions with incomplete information. In short, the winner’s curse says that in such an auction, the winner will tend to overpay. However, an actual overpayment will generally occur only if the winner fails to account for the winner’s curse when bidding. Savvy bidders will avoid the winner’s curse by bid shading, or placing a bid that is below their ex ante estimation of the value of the item for sale — but equal to their ex post belief about the value of the item, given that they win the auction. The key point is that winning the auction is bad news about the value of the item for the winner. It means that he/she was the most optimistic and if bidders are correct in their estimations on average, that too much was paid. Therefore savvy bidders revise their ex ante estimations downwards to take account of this effect.

Analysis of Winner’s Curse on Auction Rate Securities

In the case of the auction rate securities, since amount paid is fixed at par, price is determined by yield. Winners in this auction would be those with the lowest yields. Those who wanted to avoid such a phenomenon would shade their bids up to a certain level. The severity of the winner’s curse increases with the number of bidders. This is because the more bidders, the more likely it is that some of them have overestimated the auctioned item’s value. In technical terms, the winner’s expected estimate is the value of the first order statistic, which increases as the number of bidders increases.

In the case of the municipal auction rate securities (ARS) the risk of Winner’s curse appears quite high. This would make sense since they are essentially buying long term debt at short term rates, from other “winners”, in hopes that there are even more winners out there to provide liquidity. Absent of liquidity at auction, they are essentially long a long term municipal bond and short an embedded call option, as the issuer will likely call the debt to refinance it as the rates get too high. In an environment that we had the past few years, with an inverted yield curve, excess , and a outdated tax code (AMT) that causes the market for tax exempt income to grow very quickly, the number of bidders enabled a major winner’s curse to exist. Since the major investment banks “supported” this paper, they would essentially be the saavy bid-shaders, going to auction at the lowest yield to maintain order

This brings us us to the current environment we are in today. Auctions are failing and rates are rising dramatically. Two questions people have been asking is: 1) “Why wouldn’t hedge funds sweep in at this point?” , 2) “If you are getting 10%, why would you sell this thing?” It appears on service to be a an inefficiency and we keep hearing this is a liquidity problem. Well what does auction theory say about this? I believe, at this moment, the market is at a Nash Equilibrium, where all players are best off doing nothing, both those holding the ARS and those looking to possibly bid It is actually very interesting.

Those holding the paper know that there are tons of sellers and no buyers at the moment. They have no control over where they sell it and what for.. If the issuer comes under pressure from the high rates, they will most likely refinance the deal at par anyways, so they might as well get great rates up until then, as they could not get them with the money they redeemed. Their principal at this point is a sunk cost due to the illiquidity. Therefore, if their auction is failing, the marginal buyer should (but hasn’t) just hold on to it until the status changes significantly.

Hedge funds (or any outside investor) essentially are trying to collect the premium from the embedded call option that will be given to them to the need for the bond to be restructured or solution to be created. This is what yields them the best risk adjusted expected value. Holding the bond indefinitely at cap rates is not as valuable, because it is not sustainable. Therefore they have to value it as either an instrument that will experience a yield reduction, or one that will default before it is able to pay. They instead would value it on the premise that it will be called and they could essentially swoop in to collect the call premium then let the bond be called at par and will set a rate off of this. The problem is these investors are savvy and know there is tons of supply out there. Plus, they know that the auctioneer in this market, the banks, do not plan on keeping these auctions going and are concerned with returning their conservative investors money at par as cheaply as possibly. They are then long the embedded call option. They have considered this a sunk cost at this point (most likely have written it off) and would be willing to put in enough bids at the lowest outside bid, should it get to a profitable level for them. They therefore value this security the same as hedge funds and if bids approach this value, they would have no problem filtering it into the hands of speculative investors who they feel no obligation to repay at par. Therefore they could go to auction at below whatever an outsider would at potentially any price, but most likely if they see any demand out there. Speculators know this and therefore have no real incentive to put a bid on the securities at all. They know that even if they all collectively bid the higher rate, the banks have much less of an incentive to reward an aggresive speculator than a risky investor and could get stuck holding an investment that they don’t value highly at all.

The only people I could possibly see entering this trade are holders in a muni swap that many of the issuers buy when they issue these securities. The issuer locks in a fixed rate and a bank or hedge fund pays the variable rate. Those involved in these swaps could bid on these bonds in hopes to close out one side of these swap positions, because in essence they would be paying themselves. I don’t know much about these swaps, but they probably been entered into NOT based on the rate of the security itself, but on a published municipal bond rate or other benchmark interest rate such as LIBOR - which doesn’t reflect the auction rate market. Therefore, if this is the case, most are probably actually making money on that swap contract.

As elaborated on above, this auction, as it currently exists, is a game with two major players: 1) those who currently own the security, and 2)those who are looking to bid on the security. The bank and the issuer as players but part of the game. The bank is simply the auction house and municipality is that which is being auctioned. The fact that this is a Nash Equilibrium is interesting. Here we are, playing a game of investing in the financial markets. At a major point of dislocation, where everyone is saying we have a major liquidity issue that must be fixed, we are actually not a point of disequilbrium, but equilibrium itself. Investors can try to sell all they want, but the marginal investor is better off cashing out on high interest rates until their call option is exercised. Outside investors can bid all they want, but the marginal investor is better off not bidding, as he is now a speculator and to the risk of holding the bag. Although fear has taken hold, investors should not want this to be sold and possibly not restructured, as they are possibly finally beginning to be paid appropriately for their risk.

Investors are beginning to be paid for their risk because the risk they bought, was not the risk they thought they were taking. Banks supported auctions for eachothers municipal debt for years in order to collectively win auction rate municipal business. This caused financing costs to be lower than they should have been by the spread between the short term municipal rates and the long term municipal rates. Since most of these were insured to AAA, they were underwritten (probably indirectly) based on the credit quality of the insurer. At offering they were hardly a municipal bond, but essentially a synthetic credit default swaption on the bond insurer offered to conservative investors seeking tax exempt income. The variable rate element of the security essentially only comes into play if the insurer faces downgrade and liquidity dries up - as has occurred recently. The market existed based on the fact that many would be out to buy it, much like a baseball card, speculative tech stock, or tulip. Since it was a fixed-income instrument bought for liquidity, and credit enhanced by the bond insurer, the credit quality of the underlying was never really question and has not been reviewed since it was issued.The bond insurance was the reason for the AAA rating, it is difficult to say what it would be, especially given the fact that the municipality must pay much higher rates than it anticipated (think exploding ARM). It also caused companies like Ambac and MBIA to write insurance that should it ever get triggered, they would probably not be able to pay anyways, because the probability that they would become insolvent given their own crating downgrade was very high. This is a type of insurance that many people would write any day. The municipalities, on the other hand, thought they were financing themselves cheaply, but instead simply bought this synthetic derivative, forced to pay more interest when its Credit Enhancement no longer becomes enhanced.

Just as auction theory would dictate, the winner’s curse may have come true. Winners ended up bidding lower rates than they really should have, given no secondary market, many people who were seeking extra yields (like those who in the “enhanced” money market funds), increased desire for tax exempt income, shaky equity and money markets, and bank support of the auction, most likely bid too much for something too risky. The problem with a Dutch auction of variable rate debt is that the price paid is par regardless of the interest rate that is bid. Since the lowest “bid” clears the market, and most people go with the same amount of money regardless, the auction market is much more subject to the actions of the greatest fool, and collectively bears the winner’s curse. A lower interest rate generally dictates a safer issue, but it is actually the opposite when it is being bid on. The more aggressive the auction for debt, the more debt can be auctioned causing a speculative bubble in something that doesn’t appear to be speculative. Those running the auction should not participate in the auction because they profit from underwriting the debt, and can artificially create demand at a low cost, or perhaps even a gain, and underwrite more debt. Therefore, these securities were designed to have a third-party bank underwrite the debt, and another agent run the auction to eliminate this conflict of interest - in theory.

In bid-rigging, collusion between individuals causes prices to be fixed above what a market clearing price would otherwise be. In Supercrunchers, Ian Ayres tells a story of a series of sealed-bid first price auctions for consturction jobs by a New York a city official. They couldn’t figure out how they were rigging the bids for some time until Ayres was hired to figure out why. He discovered that they designed a format where all bids were given in sealed envelopes, including the one from the company rigging the bids. The official (in on the bid-rigging scheme) would put the envelope of his partner in crime on the bottom of the stack and after reading through all the bids would write in a bid just above the winning bid up until that point. They would rotate rotate companies and businesses in order to make it look almost natural.

The banks, by supporting these auctions (and not allowing a secondary market to trade) they were able to conspicuously “collude” by connecting this product to the much larger global money market through a loose arbitrage. Since the banks give “price talk” to those going to auction for the bonds, they in essence are able to steer the demand since most people will go to auction in the range that they give. If they are unable to get the bids they wanted, they were able to clear the market in order to portray stability and liquidity. I don’t know if this was intentional, but it was the reality of the situation. The fact that the third party underwrote the debt meant its own clients did not buy it. Since they issued it without a LOC, and, no real reason to care about underwriting standards existed. They had two of their major clients, the bond insurers and the rating agencies (both of whom they were throwing tremendous amounts of business at) act natural facilatators to this. The bond insurers gave it the necessary credit rating and the ratings agencies gave it a market through their issuance of a AAA rating.

This seemed harmless at first, but as the expansion of credit and Alternative Minimum Tax have created more demand, it became more and more profitable to offer municipal bonds. The traditional underwriting/distribution channel left them with too much risk of holding up inventory and tying up their balance sheets. Instead, banks embraced a product matching the demand for yield in one time period and the supply of financing in another. They were able to create confidence in the product by manipulating a market through a bid-rigging scheme.

At this moment in time, as auctions are failing and many investors in these securities are eager to sell a security earning a rate that is far above that of a “similar” security, and nobody is stepping in to be that person. Unfortunately, this could actually be the rate that these securities should yield - possibly more. I contend that this has more to do with the fact that whether they realize it or not, they are at a Nash Equilibrium of a very twisted, and complicated game, and until the game itself changes, I doubt much will happen. What is perhaps scarier is the fact that this game is not isolated to just these securities, or the auction process inherent to these and similar securities. Any public dutch auction of debt will have similar characteristics. The existence of a secondary market allows for a more bumpy and dynamic journal along many equilibria.

The word Dutch auction derives its name from the Dutch tulip auctions that accompanied a strange, but enormous speculative mania is 17th century Europe. The above figure shows the Dow Jones 40 bond index during the time leading up to and through the Great Depression and the Bond Buyer’s 20 Index. It was posted by Market Oracle in June and regardless of the apparent issues with scale, it is interesting to see where we are today, facing what we face. While, this may not be of the same magnitude or nature, I will end with a description of one such auction written by Mark Frankel of Business Week wrote in 2000,

Soon after, the tulip market crashed utterly, spectacularly. It began in Haarlem, at a routine bulb auction when, for the first time, the greater fool refused to show up and pay. Within days, the panic had spread across the country. Despite the efforts of traders to prop up demand, the market for tulips evaporated. Flowers that had commanded 5,000 guilders a few weeks before now fetched one-hundredth that amount.