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

|An~ example of a balloon was the 1982 to 1984 explosion of instruments tailored so the corporate investor could take advantage of the 85 percent tax exemption of dividend income ... Never have financial promoters shown greater imagination; they lifted the tax avoidance industry to a new level of illusion. As might be expected, promoter fees were high, but initial demand proved extraordinary. For adjustable rate, preferred stocks investor excesses were particularly evident. At the peak in February of 1983, an ARPS security was priced with an adjustable return nearly 500 basis points below the yield on the appropriate benchmark, Treasury security. At that point, the balloon quickly deflated, and the negative differential declined. The 1984 Tax Act further deflated this balloon, but the opportunities have not been extinguished.

One implication of Van Horne's analysis is that the contraction of the market for auction rate preferred has been caused by a mitigation of the conditions that spawned its development. Here, we hypothesize that the market has been adversely affected by (i) a reduction in the corporate dividends-received-deduction that decreased the tax subsidy to auction rate preferred stock, and (ii) a reduction in the availability of nondebt tax shields (in the form of depreciation write-offs and investment tax credits) that increased the availability of the tax subsidy to debt financing. The combined effect of these changes would appear to have increased the cost of auction rate preferred capital on both a relative and absolute basis, providing an additional catalyst for the contraction of the market.

Exhibit 1. Comparison of the Tax Advantage of Auction Rate
Preferred Stock Relative to a Money Market Instrument Under
Original and Revised Tax Laws

                                            Yield
                    Auction     Money       Advantage
                     Rate       Market    (basis points)

Pre-tax yield        8.00%      10.0%          200
After-tax yield
original tax laws    7.45%(a)   5.4%(b)        205
After-tax yield
revised tax laws     7.18%(c)   6.6%(d)         58

Notes:

The corporate tax rate under original tax laws is 46% versus
34% under the revised tax laws. Corporations were allowed to
exclude 85% of dividends received from taxable income under the
original tax laws; under the revised laws the
dividends-received deduction is 70%.

a 8% - 8% (1-0.85) (0.46).

b 10% - 10% (0.46).

c 8% - 8% (1 -0.70) (0.34).

d 10% - 10% (0.34).

At the time of its introduction, corporations were allowed to exclude 85% of their dividend income from taxation at a maximum rate of 46%. Since 1986, however, the value of this tax break to corporate investors has been curtailed. The Tax Reform Act of 1986 lowered the exclusion to 80% against a reduced corporate tax rate of 34%; a further reduction in the exclusion to 70% became effective for dividends received after December 31, 1987.

Exhibit 1 demonstrates the extent to which the reduction in both corporate tax rates and the dividend exclusion reduced the tax advantages of holding auction rate preferred as a substitute for taxable money market investments. A money market instrument yielding ten percent returned 5.4% on an after-tax basis under the tax regime existing at the time auction rate preferred stock was introduced. An auction rate preferred issue trading at 80% of the money market yield would have returned 7.45% after-tax, providing a 205 basis point yield advantage.