Corporate Governance

From the Pages of The Pomerantz Monitor: The Market for Auction Rate Securities Freezes Up

By Carolyn Moskowitz

As Shaheen Rushd writes in the current issue of The Pomerantz Monitor, auction rate securities form a $330 billion market. Issuers include closed-end bond funds, cities, municipalities, student loan companies, and nonprofit entities. Brokers mostly sold auction rate securities to conservative investors, marketing them as being as liquid as cash but with better yields. But investors were recently stunned to find that no one wants to buy auction rate securities any more and they cannot be converted into cash.

Auction rate securities are debt instruments whose interest rates are reset every seven to ninety days at auctions held by Wall Street dealers. Until recently, investors could readily convert them into cash by selling them at auctions. But with the subprime mortgage meltdown and the related credit crunch, buyers for the securities evaporated and auctions began failing. By February of this year, auction rate securities had become almost completely illiquid even though they were not subprime and were not in default.

Brokerage houses reportedly sold the securities to investors without disclosing the risks that the auction market might dry up. In fact, unbeknownst to investors, real auctions have not been occurring in recent years. Instead, the Wall Street firms in charge of the auctions acted as bidders themselves. Investors were unaware that these few firms formed the entire market for these securities.

Corporate America woke up to the problem much sooner than individual investors. Corporations, which owned $170 billion face amount of auction rate securities as of July 1, 2007, had apparently unloaded half their holdings by the end of the year, leaving the average investor holding the bag. The question is whether, as corporations sold, brokers were steering individuals to buy in order to bail out their corporate clients.

Meanwhile, people who believed they had invested in cash-like securities do not have access to their principal, and there is no end in sight. Only a handful of issuers have expressed an interest in redeeming early, and a few issuers have refinanced the securities or started bidding in their own auctions. But that?s only a drop in the bucket. The Financial Industry Regulatory Authority (?FINRA?) has suggested that investors who need to access their cash might borrow from the brokerage firms against the value of their holdings. But as FINRA itself acknowledged, there are adverse tax consequences and risks associated with this strategy. Adding to the pain, UBS and some other underwriters are marking down the value of auction rate securities in their customers' accounts.

The consequences of illiquidity can be serious. As the head of America Watchdog said in discussing complaints he received from over a thousand investors, "The majority of people have $200,000 to $300,000 invested, but it's their life savings, and they were told this was the same as a money market or C.D . . . I must have 50 or 60 people that were buying houses that were supposed to close in March and their earnest money is at risk of forfeiture because they relied on the liquidity of these things."   

Full post as published by PomTalk on May 06, 2008 (boomark / email).