The Wall Street Journal-20080215-Where Will the Crunch Hit Next-- Closed-End Funds That Wield Leverage Expect Trading Delays

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Where Will the Crunch Hit Next?; Closed-End Funds That Wield Leverage Expect Trading Delays

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The freeze-up in the little-known but important "auction rate" debt market is starting to create big problems for leveraged closed-end funds and their investors.

Closed-end funds are a cousin of mutual funds that issue a fixed number of shares and essentially trade like stocks. To boost returns for common shareholders, many closed-end funds employ leverage, which essentially involves borrowing at short-term interest rates and investing the proceeds in higher-yielding assets.

That approach, however, is now coming under extreme pressure, as the auction-rate securities market many of the funds tap for borrowing has seized up. In recent days, hundreds of such auctions have failed amid the broader credit crunch.

Besides closed-end funds, the lack of trading is also hurting big borrowers like student-loan authorities and municipalities.

The situation is an uncommon one for closed-end funds, which account for more than $60 billion of the $330 billion auction-rate market. Failed auctions in recent days are prompting fund companies to seriously consider a variety of potential solutions. This includes trying to find buyers for auction-rate securities in a secondary market, finding other short-term debt funding besides auction-rate securities, or, in what's being viewed as a worst-case scenario -- "de-levering," or selling some assets of the closed-end fund to raise money for auction-rate redemptions.

Several Wall Street firms and banks including UBS, Citigroup and J.P. Morgan have weighed in over recent days outlining such alternatives. Meanwhile, brokerage firms like Raymond James are trying to deal with clients who might want to pull money out of such funds right now but might not be able to.

"We expect to experience delays" in trading, said a note to Raymond James's brokers recently. "Please have patience" as we "do not know how many orders will be filled, if any" for the preferred auction securities of closed-end funds.

Auction-rate securities reset their interest rates as frequently as every seven days, and have historically been viewed as easily tradable short-term debt. As the fallout from the subprime-mortgage collapse that forced more than $100 billion in write-downs at Wall Street banks ripples through the markets however, such short-term vehicles have taken a hit.

The troubles plaguing bond insurers who back such securities have only further pressured the market.

In typical times of slack demand, broker-dealers would have taken such excess securities onto their books. However, the abundance of such debt landing on many financial firms' balance sheets has made it much harder to take on more such credit exposure.

Using leverage in closed-end funds has always posed certain risks for investors, including more volatility in underlying share values than for unleveraged funds and the susceptibility to interest-rate movements. As auctions for the preferred securities issued by closed- end funds fail however, a new risk has emerged: Many investors are having trouble pulling money out.

Issuers aren't obligated to redeem the securities, meaning in many cases investors need to wait for the next round of auctions to try to resell in coming weeks. If leveraged funds remain unable to tap the auction-rate markets, their borrowing costs are likely to rise. That could push down the dividends they pay out to certain shareholders.

Investors unable to cash in their shares will get a payoff -- higher rates -- for waiting. Closed-end funds generally use a formula in which the interest rate they pay out resets to a higher rate if shareholders are unable to auction their shares. Thus, while the relevant rate was 3.02% a few days ago, investors in some tax-free auction-rate preferreds received a tax-free rate of 3.32%, according to estimates from an analyst at Stifel Nicolaus.

To deal with such issues "funds across the spectrum are reviewing all potential options," says Ken Fincher, vice president at Calamos Investments. The firm has five closed-end funds with about $6 billion in assets, many which experienced failed auctions this week, along with funds from firms like BlackRock Inc., Eaton Vance Corp. and Nuveen Investments Inc.

Yesterday, J.P. Morgan analysts estimated that firms like Eaton Vance had $5 billion of exposure through the auction-rate market and Calamos had about $2.3 billion.

Citigroup estimates that about 240 of the 270 municipal bond closed- end funds use leverage, while almost 140 taxable bond funds use leverage.

(see related article: "Heard on The Street: Mortgage Insurers, Latest Corner Exposed,Stare at Downgrades" -- WSJ February 15, 2008)