Financial innovations and excesses revisited: the case of auction rate preferred stock - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Michael J. Alderson, Donald R. Fraser

Redemption behavior represents only one side of the natural selection hypothesis, however. Under the behavior characterized by that theory, the market not only discriminates against high-risk issues but selects in favor of low-risk shares. To explore the full symmetry of the theory, we also examine the characteristics of firms that have issued new auction rate preferred shares concurrent with the surge in redemptions (which began in 1988). In this test, the timing of the issue (before 1988 or after 1987) is also related to the variables that measure cross-sectional differences in risk.

B. Regulatory Changes

1. Thrift Reform

Following the first thrift auction rate preferred issue in November 1985 (a $75 million issue by City Federal Savings Bank), thrifts became major sellers of this type of security, with over $4 billion outstanding by April 1987 (representing 42% of the total market).(10) A number of factors account for the attractiveness of this type of financial instrument to thrifts.

Issuing auction rate preferred is an attractive financing alternative for non-tax-paying entities, a characteristic that certainly applied to many large thrifts throughout the 1980s. Particularly relevant to thrifts, however, is the ability to lessen funding costs even further by segregating marketable securities (mostly mortgage-backed securities) in a special, limited-purpose subsidiary and raise funds at or near an Aaa rate. Also, thrifts are able to use these securities as a form of overall asset/liability management.

Most thrift issues are sold through limited-purpose subsidiaries, corporations formed solely for the purpose of selling the auction rate preferred and managing the assets that support it. In order to avoid existing limitations on the amount of assets that may be devoted to any one use, the Federal Home Loan Bank Board referred to these organizations as "nonsubsidiary" subsidiaries funded with "noninvestment" investments.(11) The assets of the subsidiary (at least 55% of which must be GNMAs, FNMAs, or FHLMCs) must substantially exceed (in some cases by as much as 70%) the value of the auction rate preferred.(12) The securities became highly rated because of their over-collateralization and also due to the willingness of the thrift regulator (the Federal Home Loan Bank Board prior to 1989) to recognize the "corporate veil" in the event of the failure of the parent.(13) This allowed thrifts to use special-purpose subsidiaries to conduct tax arbitrage by offsetting taxable earnings from the subsidiary against the operating losses of the parent.

We hypothesize that a confluence of factors gravitated against thrift participation in the auction rate preferred market beginning in 1989 and that these factors contributed to the observed contraction. The test of this hypothesis relates a classification variable that identifies auction rate preferred shares sold through limited-purpose subsidiaries to both the redemption and issue timing decisions. The thrift crisis itself affected the market receptivity to any securities from this industry, and resulted in larger credit risk premiums for thrift issues. Moreover, the passage of thrift reform legislation in 1989 and of the Revenue Reconciliation Act of 1990 dramatically affected portfolio management practices at thrifts.