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Market Description (Continued)

Auction-Rate Securities Market

The term “auction-rate securities” (ARS) is used to refer to the universe of (formerly) highly liquid long-term debt and preferred securities, issued mainly by corporations and municipalities, which changed hands frequently at variable interest rates reset through a Dutch auction process. These securities include municipal auction-rate securities (MARS), or bonds issued by municipalities; auction-rate preferred securities (ARPS), or preferred shares issued by closed end investment funds; student loan auction-rate securities (SLARS), or bonds sold by student loan issuers; and other ARS issued by corporations, non-profits, collateralized debt obligations (CDOs), etc.

First developed in 1984, the auction-rate market grew steadily over time to over $300 billion by the end of 2007. Auctions were typically held every 7, 28 or 35 days, at which time the sponsoring broker-dealers would match buyers and sellers through a competitive auction process, setting interest rates accordingly. The underlying credit quality of auction-rate securities was very good, with the vast majority being AAA rated. In times when more ARS were offered for sale then bid upon, broker-dealers often would step in to “support” the auctions by purchasing ARS to help correct the imbalance, which is one of the reasons why so few auctions ever “failed” over the years. Due to this combination of high credit quality, implied liquidity and broker-dealer sponsorship, these securities were sold to investors as cash equivalents- offering a slightly better yield to treasuries.

In February 2008, with the credit crisis well on its way, auctions began failing en masse. With a flood of sellers, dwindling buyers, and broker-dealers unable to support auctions by taking the securities on their balance sheets - all ARS auctions failed on some days. While many municipalities, closed end funds and student loan issuers have been able to replace their auction-rate securities with alternative sources of financing, approximately $160B of ARS remain outstanding as of January 2009, with the majority of auctions continuing to fail daily.

Student Loan Auction-rate Securities (SLARS)

Student Loan Auction-Rate Securities (referred to as SLARS) are long-term (often 30 year), asset backed bonds issued by a combination of corporations, non-profit organizations and state agencies. These bonds were issued out of a trust structure, which essentially were formed from the securitization of thousands of underlying student loans contained within each trust. As students repay their interest and principal payments, SLARS interest payments are made, and bonds are redeemed over time. Issuing SLARS became a popular financing tool for student loan issuers, as the federal government mandated thin operating margins and low interest rates to student borrowers. The credit quality was also very high, due to the fact that the majority (95% plus) of the underlying student loans were backed by the Federal government.

The majority of SLARS issuances were structured in such a way that maximum rates triggered at failed auctions were capped, such that interest paid to bondholders never exceeded interest income and expenses incurred by the trusts. This left SLARS investors receiving less than 3% interest in some cases- rates so low that issuers had little incentive to search for alternative financing. This is one of the reasons why less than 10% of SLARS have been refinanced by issuers, among other factors. Student loan issuers Sallie Mae, the Pennsylvania Higher Education Assistance Agency and College Loan Corporation were three of the largest SLARS issuers.

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