Auction-Rate Securities

“If it is too good to be true, then it not true”

If you are counting on the Wall Street Firm that sold you the bonds, to now make a bid near par for them, then I feel you are guilty of being Pollyannaish. The old Wall Street Joke is “Where are the customers’ yachts?”

Introduction:

Over the past week the Wall Street Journal, has had a number of articles about another gross misrepresentation by Wall Street firms- The $330 Billon Dollar Auction-Rate Securities Market– that will cost investors and possibly Wall Street Billions of Dollars

Unlike some of the other Wall Street problems, this problem has personally impacted many of my friends. That is, I have received calls from at least ten people about their problems with auction-rate securities. In a nutshell, while each security is different, there are in general several major problems with auction-rate securities.

1. In almost all cases, after several failed auctions, the bonds become long term bonds having the original coupon. Thus, investors are stuck with below market rate interest rates on their holdings. Thus, the investor will take a capital loss when he sells the security because the coupon will not be competitive with rates available in the general market.
2. The problem is exaggerated because suddenly holders will have some $330 billion of long-term bonds. Most of these holders only wanted short paper, and thus want to sell them. Thus, for an extended period of time, the market will be oversaturated with long paper for sale. That is, $330 billion of 30-year maturity paper is significantly greater than the annual demand for long municipals.
3. Pig in a Poke. While currently the problem is liquidity; that is, investors cannot get cash for their securities. Moreover, given that nobody can put a realistic time schedule for when the problem will be cleared up, it is difficult to put a realistic parameter on either timing or price. That is, “how can you sell a security whose coupon is not determined or whose maturity is not determined.”

What is a Auction-Rate Security?

Auction-rate security is a long-term bond (mostly municipals) that traded until recently like a short term instrument. Thousands of issuers from the Port Authority of New York and New Jersey to the Metropolitan Museum of Art in New York City have issued auction rate securities.

What securities were put into auction-rate securities?

These securities were generally municipals, but investors could also participate in preferred stock or corporate bonds.

The “catch” (with Wall Street there seems always to be “a devil in the details”) was that investors would invest in a pool of long-term securities. However, these securities issued by municipalities, student-loan authorities, museums, and many others would have interest resets through bank managed auctions every week to thirty-five days. Thus, in theory the securities would always trade near par because the auction mechanism would assure the investors that the yields would be competitive with the offerings provided in the current interest rate environment.

Why did it trade like a short-term piece of paper when its stated maturity was 30 generally thirty years?

In order to provide investors ample liquidity, dealers held auctions in auction rate securities frequently, between every 7 days and 35 days.

What caused this market to “freeze up?”

The mounting problems of bond insurance companies like MBIA, AMBAC, and FGIC made investors nervous about holding municipal bonds. That is, once investors feared that their municipal bonds were not “enhanced AAA” because of the purported wrapping of the municipal bond with a AAA insurance guarantee, investors shied away from municipal bonds in general and “auction-rate” municipal bonds in particular.

Egregious Example of Misrepresentation?

In essence, Wall Street convinced investors looking for “slightly higher yields” that they could have both security and liquidity by investing in long term auction-rate securities. In essence, the investor wanted a short-term high-quality investment. To receive higher yields, the investor bought in essence long-term securities.

How does one have the best of both worlds?

 Specifically, the benefit of yields higher than short term securities, but the liquidity of short-term paper?

THE ANSWER—-YOU CANNOT!

And along came Jones (Jones is a euphemism for an on-rushing train)

Suddenly the “so-called” liquidity dried up like an old prune. That is, many of the auction-rate securities are backed by troubled bond insurers, like Ambac Financial Group and MBIA and commercial banks. These insurers given their enormous exposure to the sub-prime market have lost their credibility. The commercial banks guaranteed (off the balance sheet) the investors that they would step in if the auction failed.

In essence, my suspicions are aroused that commercial and investment banks have more “off the balance sheet” than “on the balance sheet.”

How bad is bad?

Today’s Wall Street Journal pointed out that again “off the balance sheet” commercial banks have guaranteed at least $40 Billion of auction rate securities. That is, the commercial banks and bond insurers guaranteed investors that they would step in and provide liquidity. The current melt-down of these auction-rate securities will be another severe test of Wall Street’s credibility.

Who will make money?

Class action attorneys