‘Unfreezing’ the Student Loan-Backed Auction Rate Securities (SLARS) Market Would Create up to $63 billion of Stimulus and 441,000 Jobs

The SLARS market failed in February 2008 due to problems originating elsewhere in the U.S. credit markets. A new coalition of non-bank investors hopes to help restore liquidity to this market – potentially creating up to $63 billion of stimulus and up to 441,000 jobs.

While the SLARS market remains indefinitely frozen, many of these non-bank investors have been unable to utilize funds that would otherwise have gone to economically stimulative capital expenditures. Members of the “SLARS Coalition” hold approximately $8 billion of the aggregate $25 billion estimated to be held by non-bank corporation. Their goal is to advocate for a broader solution to the overlooked SLARS marketplace and, in so doing, to generate broader economic growth that would speed the recession recovery.

History and Current State of the Illiquid SLARS Market

SLARS investors include individual retail investors as well as more than 250 non-bank corporations holding approximately $25 billion in these securities. Historically, investors bought SLARS because of the excellent credit quality, liquidity, and competitive return they offered compared to other highly-liquid money market investment alternatives. SLARS, unlike other auction rate securities, had been seen as particularly secure investments because the vast majority of the student loans acting as collateral were issued under the Federal Family Education Loan Program (FFELP) and are insured by the Department of Education (DOE) for 97 percent of the principal and interest. For roughly 20 years the market functioned well for both investors and issuers. However, the market for SLARS failed in February 2008 due to problems originating elsewhere in U.S. credit markets. Since that time, private institutions and credit markets have been unable to offer an industry-wide solution which would restore liquidity to SLARS or which would allow the underlying government guaranteed student loans to be refinanced. In the meantime, funds that had been intended for productive uses remain unavailable to investors.

In the fall of 2008, following market investigations, the SEC and the Office of the N.Y. Attorney General filed lawsuits against several SLARS broker-dealers (investment banks), ultimately resulting in settlements that required the broker-dealers to buy back the securities they sold to their retail (individual) investors. In Consent Orders these broker-dealers were also required to make “best efforts” to provide liquidity solutions to non-bank corporate investors by December 31, 2009. Despite the directives from the SEC and NYAG, as of fall 2009, the vast majority of SLARS investments remain frozen on the balance sheets of these non-bank corporate investors.

SLARS Investors and the Consequences of the SLARS Problem

Non-bank SLARS investors are large and small companies representing a wide variety of industries, including manufacturing, retail, technology and health care, among others. Frozen SLARS investments have prevented these companies from accessing funds invested in SLARS, which otherwise could have been used for capital expenditures, expansions and for spending that increases output, income and employment in many industries across the whole economy.

Unexpected liquidity losses for many companies have altered ongoing operations, forcing firms to find alternative financing or curtail activities in order to satisfy other debts.

Ash Grove Cement Company, based in Overland Park, KS and family owned for more than 125 years, held in excess of $300 million in ARS, including more than $60 million in SLARS, when the markets failed. The company expected to use the funds for several activities, including the acquisition of a fine-aggregates company, expansion of a cement plant in Arkansas and for annual capital replacements. Unable to access the funds, Ash Grove had to borrow money to complete the acquisition, contrary to the company’s standard financial practices.

“Within the past two years, Ash Grove has had to significantly reduce (by approximately two-thirds) its annual $50-$60 million expenditure for capital replacement activities,” said John Woodfill, vice president of finance at coalition member company Ash Grove Cement. “Capital replacement activities, such as new equipment purchases and updates to manufacturing and mobile equipment, are a key element of Ash Grove’s commitment to the having most up-to-date and well-maintained facilities.”

While the failed SLARS market has not stopped Ash Grove from making acquisitions or completing projects, it has forced the company to take on debt and has impacted long-term plans for further growth.

The negative economic effects of SLARS illiquidity have been felt throughout a wide range of industries, given the diversity of companies holding the securities when the markets failed.

Intevac, a California-based high technology company employing approximately 375 people, holds $70 million in illiquid SLARS. The company was led to believe that these securities were sound investments that provided access to their principal on either a weekly or monthly basis. When the auctions failed in February of 2008, the company was considering investments in major new product developments and a potential strategic acquisition.

“While we had enough cash to support our ongoing working capital needs for our existing businesses, our plans for these activities were either scaled back or put on hold as a result of this capital not being available for long-term strategic investments,” said Norman H. Pond, chairman, of coalition member company Intevac. “In the high technology industry, companies succeed by developing new products internally and/or through acquisitions in a timely fashion, and this SLARS problem has caused Intevac delays. We firmly believe that not having access to this capital negatively impacted Intevac’s employees and suppliers.”

SLARS Coalition

In order to seek a constructive solution to the SLARS problem that would positively impact the broader economy, more than 25 non-bank investors have joined to form the SLARS Coalition, which is working to bring this issue to the attention of Members of Congress, the Department of the Treasury, the SEC and the Office of the N.Y. Attorney General.

The coalition commissioned University of Delaware economists James Butkiewicz and William Latham to investigate the potential impact that a systemic solution for non-bank SLARS investors would have on national economic growth, and to publish their research in a whitepaper.

This whitepaper concludes that restoring liquidity to $25 billion of the frozen SLARS market currently held by non-bank investors would generate an immediate $58 billion to $63 billion of economic stimulus. If the restored liquidity was spent for capital expenditures in a single year, a total of 441,000 jobs would be created.

“The strain put on companies holding illiquid SLARS, such as heightened borrowing costs and weakened earnings, has the effect of aggravating the scarcity of credit and financing that many companies have experienced since the onset of the recession, which in turn further depresses overall economic activity,” said Jim Butkiewicz, whitepaper co-author and professor of economics, University of Delaware. “Restoration of liquidity to these securities would result in immediate stimulative effects from business capital investment and would likely be more rapid than those from the federal stimulus program.” As the whitepaper points out, a weakened balance sheet reduces the willingness of lenders to lend to affected companies and the loss of liquidity reduces business investment and overall economic activity. The report goes on to cite a forthcoming work by Brown, Fazzari and Peterson that found that access to finance is especially important for research and development.

The resulting economic stimulus from a restoration of SLARS liquidity ranges in scale from $58 billion to $63 billion, depending on the how the companies utilize the freed funds – capital expenditures, employee re-hiring and hiring, or debt repayment. No matter how the funds are utilized, however, the whitepaper estimates that every $1 billion of liquidity restored would result in a minimum of 15,000 jobs and at least $2.3 billion stimulus.

To access the whitepaper, please visit http://www.lerner.udel.edu/departments/economics/newsevents.

To access the SEC and NYAG Consent Orders, please visit www.oag.state.ny.us/media and www.sec.gov.