Auction-Bond Flops Stick Student-Loan Holders With 0%

By Michael B. Marois and Jeremy R. Cooke

April 25 (Bloomberg) -- More than $9 billion of auction- rate bonds sold by student-loan agencies in U.S. states from Pennsylvania to Utah have trapped investors in debt that's not paying interest.

Rates on Pennsylvania Higher Education Assistance Agency bonds backed by student loans were set at 0 percent April 4 after auctions to determine interest costs attracted too few bidders. The same occurred on more than 10 percent of the $86 billion of student-loan debt, as failures triggered provisions in bond documents that limit the interest agencies must pay, according to data compiled by Bloomberg.

The collapse of the auction-rate market drove interest costs paid by states, hospitals and student-lending agencies as high as 20 percent, and froze investors in securities they couldn't sell. Now, holders of student-loan debt are stuck with bonds paying less than the 0.66 percent rate on the one-month Treasury bill.

``It's hard to explain, to conceptualize or even understand how someone can borrow money and not pay you interest,'' said Mike Saunders, who manages $1 billion in taxable student-loan bonds for Acton, Massachusetts-based Roundstone Advisors.

The bonds pay nothing because of a formula designed to ensure that borrowers don't pay more interest on their debt than they receive from their student-loan clients. The mechanism kicked in as rates climbed above 10 percent since February, when dealers stopped buying securities that went unsold at auctions.

``The investor loves you when he sees the 10 percent coupon, but how do you explain to him that it's gone from 10 percent to zero?'' Saunders said.

A Utah State Board of Regents bond with interest that changes every 35 days jumped to 16.58 percent on March 5, up from 3.8 percent in January. The same bond's interest then dropped to 0 percent on April 9, when the provision took effect.

Rates on $97 million of bonds sold by the Pennsylvania lending agency more than doubled to 9.85 percent on March 7 before falling to 0 percent this month.

The formula typically is based on a 12-month average of benchmark money-market yields, which have fallen as the Federal Reserve slashed its target rate for overnight loans between banks to 2.25 percent from 5.25 percent in September.

Auction-rate bonds are long-term securities with interest rates determined through bidding run by dealers every seven, 28 or 35 days. When there aren't enough buyers, the auction fails and the rate resets to a level proscribed when the obligations were initially sold.

The $330 billion auction-rate market unraveled in February after investors shunned the debt and dealers that had routinely stepped in as buyers of last resort stopped supporting the securities under the weight of subprime-related losses.

More than 60 percent of the thousands of auctions conducted each week have failed since Feb. 13, data compiled by Bloomberg show.

The collapse left public student-loan issuers unable to raise additional capital in the market. No new municipal bonds backed by student loans, including auction-rate debt, were sold in the first quarter, the first time that happened in almost 40 years, according to Thomson Reuters.

``We need bonds that are out there for 30 to 40 years,'' said Jamie Wolfe, chief financial officer of NorthStar Education Finance Inc., a nonprofit organization in St. Paul, Minnesota, that provides student loans to medical students. ``That's what these auction bonds do for us.''

Without access to funds, NorthStar stopped processing applications this month for federally backed loans, joining dozens of state agencies, private firms and nonprofit groups that have curbed lending to students.

NorthStar bundled $800 million, or 20 percent, of its loans into auction-rate debt sold to investors since 2002. One $30 million issue of NorthStar bonds reset at 0 percent on March 5 from 6.9 percent in January.

``I'm dealing with people who have tax payments and payroll to meet with what they thought were liquid funds,'' Wolfe said of NorthStar's investors.

JPMorgan Chase & Co. this week said it will buy as much as $1.1 billion in auction-rate notes from three student-loan trusts created by a company the New York-based bank later bought, providing limited relief to some investors.

Cities, hospitals, universities and other municipal borrowers have redeemed or plan to refinance at least $54 billion of auction debt by June 2, according to a compilation of disclosure notices by Bloomberg.

Student-loan refinancings have been rarer, since the so- called look-back formulas that cap rates are designed to prevent the trusts from becoming insolvent, said Barry Silbert, chief executive officer of Restricted Stock Partners.

The New York-based company runs the Restricted Securities Trading Network, which Silbert says provides the largest secondary market for the various forms of failed auction bonds, averaging 10 transactions a day.

``On the student loan side, there really aren't many other situations like that, where there's any expectation that there's going to be a mass refinance or tender offer,'' Silbert said.

To contact the reporter on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net; Jeremy R. Cooke in New York at jcooke8@bloomberg.net.