Corporate & Securities Law

Auction-Rate Securities Failures Due In Part To Lack Of DisclosureThat Financial Services Firms Sometimes Have Had To Intervene In Auctions Just To Prop Up Auctions According To SEC Official

By James Eccleston

The collapse of the roughly $330 billion auction-rate securities market this year was fueled by a lack of transparency and may have been avoided if investors had a comprehensive source for disclosures that showed the extent to which successful auctions were dependent on broker-dealer intervention, the Securities and Exchange Commission's municipal securities chief said recently. 

Martha Mahan Haines said that one of the biggest problems in the ARS market was its opacity, which may have kept investors from knowing that a small group of broker-dealer firms that bid on the auctions were critical to preventing widespread failures.  Even though broker-dealers disclosed that they were bidding on auctions, the extent of the participation was unknown, she said.  "If investors could see that broker-dealers were so active in this market...perhaps it wouldn't have grown so large, well beyond the broker-dealers' ability to hold it up," Haines said, speaking at the Securities Industry and Financial Markets Association's legal and compliance conference in New York.  "We may not have gotten into this mess had there been transparency," she said.

Haines' remarks were echoed by John Cross III, an attorney with the Treasury Department's office of tax policy, who said that there is a lack of basic information about auction-rate securities that likely confused many investors.  At a fundamental level, he said, market participants did not understand the difference between auction-rate securities - which have no liquidity facilities but were nonetheless widely considered highly liquid, short-term investments - and money-market eligible VRDOs, which have liquidity features and are thus eligible for investment by money market funds under the SEC's Rule 2A-7.

Liquidity facilities include lines of credit, standby bond puchase agreements, or other arrangements in which an entity, typically a bank, promises to purchase securities that cannot be immediately sold or remarketed to new investors.  Demand for ARS was fueled at least in part by the fact that they were cheaper than VRDOs, which usually include pricey letters of credit, he said.

"One of the biggest, broadest themes right now is basically efforts to dress up auction-rate securities so that they have liquidity facilities so that they can be sold to the money market funds," Cross said, referring to the push by issuers to convert their ARS to VRDOs or fixed-rate bonds.  "That unfortunately comes at a time when the financial positions and balance sheets of all the banks are equally challenged and the silver bullet of adding liquidity facilities...still faces ongoing business challenges."

In the past, banks and broker-dealers put in bids of their own for these securities to prevent auctions from failing.  But in June 2006, 15 firms agreed to pay $13 million to settle charges that they violated the securities laws by not disclosing these and other auction-rate practices.  Some firms began disclosing their practice of putting in bids to prevent auctions from failing.  But the credit crunch led banks and dealers to tighten their lending standards and in February they stopped bidding on auctions.

Source:  The Bond Buyer

Full post as published by FinancialCounsel on June 10, 2008 (boomark / email).