Auction Rate Securities
The Creation of Auction Rate Preferred Securities ("ARPS"¯)
As "Auction Rate Securities"¯ [ARS] proliferated through the market place, any short term competitive edge the original investment bankers had evaporated. It was not easy to write the business. One had to find a real municipality that had a real project which needed funding.
Investment firms introduced the closed end funds that issued preferred shares and structure and market them as ARPS. There are many types and flavors to the family of funds. Many of these closed end funds is simply entities that house long term financial assets which earn long term rates.
However, ARPS were not market based funds, that is to say they had no basis in market reality.The closed end funds issuing ARPS functioned as warehouses for long term financial assets earning long term rates. The purpose of issuing ARPS was to make additional income between what issuers can earn on their long term assets and what they can have the brokerage houses could get clients to accept.In other words, since the interest rates on the ARPS were short term rates, sometimes paying as little as 4.3% to 4.7%, the present value of security would actually be worth 40% to 50% of par value if long term interest rates on a long term illiquid investment were paying just 8% to 10%.
Wall Street made billions from the process of underwriting, administrating, acting as principal, acting as a market maker for their ARPS.After a new ARPS was first issued, it could subsequently be re-marketed in the ARS market to clients of the broker-dealer.Better yet, a prospectus would not be required before offering it to clients on a secondary market basis.Hence, the clients got no prospectus nor were they told where it could be viewed, nor that they should review it, or that it even existed.
During the second week of February 2008, most brokerage firms stopped making a market in these securities.The ARS market collapsed when failing auctions largely outnumbered auctions that succeeded, leaving ARS investors holding the bag with illiquid investments. Brokerage firms involved in the mirage of deception simultaneously abandoned their clients and brokers alike, allowing them to fail.
As early as May, 2006, the SEC issued Cease and Desist Orders to most of the brokerage firms for improper sales practices in connection with auction rate securities.However, the SEC seems to have gone for the capillary instead of the jugular vein in its misguided and half-hearted attempts to regulate the ARS marketplace.
In late 2007 and early in 2008, investors who purchased auction-rate securities "” in the form of preferred shares in closed-end mutual funds, or corporate or municipal bond instruments "” are discovering that these securities are hardly the safe, liquid, slightly higher-yielding, tax-exempt alternative to money-market funds that they were marketed as. We are currently investigating the representations made by Wall Street brokerage firms on behalf of institutional and retail customers.
In the past, auction-rate securities have been popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other not-for-profit entities because of their low financing costs and the fact there are usually fewer parties involved in the financing process and no requirements for third-party bank support.
Holders of auction-rates securities are allowed to sell them on the days in which the interest rates have been reset. The problem now is finding buyers, as the $330 billion auction-rate securities market experiences turmoil and uncertainty like never before.
Historically, auction-bond failures are rare. But in recent weeks, increasing concern regarding the credit strength of insurers backing the underlying debt obligations has led to a rapid decline in demand for the securities. Adding more fuel to the fire is the reluctance of banks like UBS, Citigroup and Goldman Sachs to submit bids in fear they could be at risk of holding too many bonds.
As reported in a Feb. 13, 2008, article by Martin Braun on Bloomberg.com, nearly half of the $20 billion in securities that went up for auction on Feb. 12 failed to generate interest among bidders. As result, no securities were sold. Merrill Lynch has gone on record that it plans to reduce purchases of any auction-rate securities that fail to attract enough bids from investors. UBS goes one step further "” it will not buy the securities, period.
Why the failure?
The failure of the auctions can be traced to investor concerns about the credit ratings of the bond insurers that back the securities. When an auction fails, issuers are forced to abandon their offerings. Or, they have to pay exorbitant interest rates, which is exactly what the Port Authority of New York and New Jersey recently had to do.
Although the interest rate on the $100 million of bonds that the Port Authority of New York and New Jersey sold during the week of Feb. 4 was only 4.3%, the rate more than quadrupled, ultimately soaring to 20% on Feb. 12.
A similar dilemma confronted the state of Wisconsin at its 28-day auction of taxable bonds on Feb. 12. Bonds that the state sold at 4.75% on Feb. 7 jumped to 10% five days later. Shortly after Ambac Financial Group, the insurer of student loan debt issued by Vermont's Student Assistance Corp., lost its AAA credit rating, the interest rate was reset from 5% to 18%.
Other bond auctions have failed outright, including bonds issued by Presbyterian Healthcare in Albuquerque, Georgetown University, Nevada Power and New York State's Metropolitan Transportation Authority and Dormitory Authority. According to New York Times reporters Julie Creswell and Vikas Bajaj, nearly 1,000 auctions failed during the three-day period between Feb. 12 and Feb. 14.
Bond-auction failures can have a devastating effect on the issuers, whose only alternative is to pay the higher interest rates or cut back on their programs. For not-for-profit entities, which depend on these instruments to raise funds for their institutions and programs, and municipalities that are forced to raise taxes to meet higher costs of borrowing, the consequences are even more severe.
In the wake of reduced tax revenues from a weakened housing market and a potential recession on the horizon, many state and local governments are increasingly worried about how they will pay their bills while still offering essential services. Michael Quint reported in Bloomberg.com on Feb. 15 that the Municipal Securities Rulemaking Board, which is the top regulator for the U.S. bond market, "is so concerned by the chaos in the auction-rate bond market that it plans to seek comment on whether dealers in these securities should reveal the number of bidders, and disclose how often these auctions fail."¯
Reportedly, the Securities and Exchange Commission (SEC), which reached a $13 million settlement in 2006 with 15 investment banks involved in bidding irregularities, also is considering whether to require increased disclosure regarding the auction process.
Investors in these securities are no doubt feeling the sting. Individual and institutional investors that purchased the bonds "” believing they were safe, low-risk securities equivalent to cash "” now find themselves holding an investment for which there is essentially no market.
As a result, legal action already is brewing by several investors against the brokers responsible for selling the securities. Case in point: Merrill Lynch is a defendant in a Texas dispute in which Metro PCS alleges the firm misrepresented the risks involved and the suitability of the securities under the company's guidelines. Another case is Lehman Brothers, which is the respondent in a FINRA arbitration complaint filed by two wealthy New Jersey brothers who allege that the firm's investment of $286 million in auction-rate securities was inconsistent with the claimants' stated investment objectives.
Should I Sell My Auction Rate Securities?
Auction Rate Securities holders are asking whether they should sell their illiquid holdings or should wait in hopes of their auction rate securities being refinanced or redeemed. Unfortunately, there is no one answer that is right for every investor. This article attempts to discuss various factors that investors may wish to consider in making their own decision. Among other things, we discuss the status of the market, describe relevant considerations and discuss the advantages of selling and of waiting. We also provide investors with information on what they can do if they are interested in selling their auction rate securities.
General
In determining whether to sell their illiquid auction rate securities, investors need to remember that no one can predict the future. It is important to appreciate that while things could improve in the auction rate securities market, they could also get worse.
An individual investor's decision on whether to sell or to hold may be influenced by a variety of important factors. For example, the investor's need for liquidity in the foreseeable future, the investor's desire to eliminate risk, and the investor's personal perspective of the future are among important factors that may well influence the investor's ultimate decision.