About one third of outstanding auction rate securities have been refunded or converted according to an article in the Bond Buyer today…
It took many years for this market to become as concentrated and illiquid as it is … so it’s no surprise that it will take at least a year to be unwound …
Liquidity availability for high net worth and retail investors will become a bigger issue … and an important issue…
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++++ Good news on the institutional side +++++++
NEW YORK: The Fixed Income Clearing Corp will restart interbank trading and settlement for its General Collateral Financing repurchase product on Thursday after a hiatus of about five years, the Securities Industry and Financial Markets Association said.
The announcement comes as financial markets generally have been on heightened alert to liquidity concerns of any kind after the credit crisis that erupted in the wake of last year’s housing meltdown.
Brokers had been restricted from executing repo agreements with their customers unless both customers could settle the transaction at the same settling bank.
“The shift from intrabank trading to interbank trading will offer dealers more access to liquidity,” SIFMA said in a statement.
GCF repos are widely used for flexible short-term financing because they allow for expanded trading time, greater flexibility on collateral and increased liquidity for market participants. Since they can be netted in the clearing process, they also offer reduced transaction costs.
On May 1, FICC announced that the Securities and Exchange Commission had approved its proposal to resume offering its General Collateral Finance repurchase agreement service to brokers whose customers settle their transactions at different settling banks.
http://economictimes.indiatimes.com/Global_Markets/FICC_restarts_interbank_GCF_repo_service-SIFMA/articleshow/3022877.cms
UBS to Make Good on Bad ARS Investments
Massachusetts municipalities will get back $35 million from the bank, which allegedly misled them about the safety of the securities.
Stephen Taub
CFO.com | US
May 7, 2008
UBS has agreed to return to various Massachusetts entities $35 million for funds invested in auction rate securities, state Attorney General Martha Coakley announced.
Oakley’s office in February began investigating allegations that the Swiss bank misled towns, cities, and state and municipal entities regarding ARS were a permissible investment for them under Massachusetts Law.
“We appreciate that UBS has taken action to return the invested monies to our cities, towns and other government entities,” Coakley said in a statement. “In these tight financial times, Massachusetts municipalities need to have access to their monies and to invest them appropriately.” She added that her review of potential penalties under the False Claims Act is ongoing.
An auction rate security is a debt instrument, such as a bond, or preferred stock for which the interest rate or dividend is periodically reset through an auction mechanism. In some cases, towns and cities were persuaded to invest their cash into ARS accounts. Although these securities have long-term maturities of many years, they historically have been offered for sale at weekly or monthly auctions.
However, the market for ARS dried up early this year, and the auctions experienced widespread failures. When an auction fails, liquidity disappears from the market, as it becomes difficult to dispose of such securities at all, let alone at par value, Coakley explained. Many of these securities have been written down to reflect their reduced market value.
The failure of the auctions has also hit companies, such as 3M Corp., US Airways, and Bristol-Myers Squibb, forcing the latter into a write-downs. Some issuers were forced to pay interest rates as high as 20 percent.
Since the auction failures, the Massachusetts that invested in ARS have been forced to hold these securities in order to avoid principal losses, Coakley noted. “UBS’s action today will allow these entities to recover these frozen funds,” she statd.
Affected Massachusetts entities include: Town of Andover, Town of Merrimac, Town of Needham, City of Holyoke, Town of Whitman, Town of Hudson, Town of Westborough, City of Chicopee, Town of Barnstable, Town of East Longmeadow, Massachusetts Turnpike Authority, Town of Wayland, Town of Boylston, Town of Warren, Town of Winchester, Town of Mattapoisett, Town of Dedham, and Town of Belchertown.
Massachusetts is not the state probe the embattled ARS market. It is participating in an ARS state task force with Florida, Georgia, Illinois, Missouri, New Hampshire, New Jersey, Texas, and Washington, according to the North American Securities Administrators Association.
In addition, New York Attorney General Andrew Cuomo subpoenaed 18 banks and securities firms, including a number of well-known large ones, according to a report in Bloomberg News. The probe could lead to criminal charges, the wire service added, citing a person familiar with the investigation.
“We’re all getting complaints on a daily basis from retail investors and they all have the same the story: they were told by their brokers these were safe as cash — and they’re not,” Bryan Lantagne, securities division director for Massachusetts Secretary of State William Galvin, told Bloomberg.
Meanwhile, the inspections office of the Securities and Exchange Commission sent letters to the biggest sellers of ARS this month, seeking names of customers who purchased the notes and the identities of brokers who sold them. The regulator is interested in how Wall Street firms sold the bonds to investors and issuers, the wire service noted.
This is not the first time investment banks have been accused of wrongdoing in the ARS market. According to Bloomberg, in 1995 Lehman Brothers Holdings was fined $850,000 by the Securities and Exchange Commission for manipulating auctions conducted for American Express.
http://www.cfo.com/article.cfm/11331610?
Citigroup Leads Wall Street Drive to Hurt Taxpayers (Update2)
By Michael McDonald
May 9 (Bloomberg) — Taxpayers from Massachusetts to California are paying Wall Street banks to end derivative contracts gone bad as they exit the collapsing auction-rate bond market, with penalties in some cases topping $10 million and compounding the pain of rising borrowing costs.
Sacramento County, California, paid Morgan Stanley $5 million to cancel an interest-rate swap agreement when it refinanced $79.5 million in auction-rate securities last month. The fee added to the cost of the bonds after the rate on the securities more than doubled to 9.8 percent in March as dealers stopped supporting the market.
“It’s kind of like damage control,” said Chris Marx, the county’s debt officer. “It didn’t make a lot of sense to us to leave the swap in place.”
The breakdown of the $166 billion market where municipal rates are typically set through bidding run by a dealer is squeezing borrowers already hurt by the first decline in state sales-tax revenue in six years, according to the Nelson A. Rockefeller Institute of Government in Albany, New York.
States, cities, hospitals and colleges face penalties exceeding $10 million to terminate swaps that failed to protect them against higher rates, according to interviews with borrowers and advisers. That’s on top of the $1 billion in fees they’re paying to dealers to help sell bonds that would replace auction-rate securities they sold, based on industry averages.
`Tough Lesson’
“Some of the termination fees are ugly,” said Christopher “Kit” Taylor, former executive director of the Municipal Securities Rulemaking Board, the market’s regulator. “It’s going to be a tough lesson for a lot of issuers.”
Though no data exists on how many municipalities entered into swaps, it was “the trade du jour,” said Robert Fuller, a financial adviser who runs Capital Markets Management LLC in Hopewell, New Jersey. Many issuers sold auction-rate securities and then agreed to swaps with their bank, leaving them with a fixed rate derived from the taxable bond market that was often lower than conventional tax-exempt rates, he said.
Citigroup, based in New York, was the top underwriter of auction-rate securities in the municipal market, arranging $55 billion in sales between 2000 and the end of last year, according to data compiled by Thomson Reuters. Zurich-based UBS AG, which said on May 6 it will close or sell its municipal bond department, underwrote $42 billion, followed by Morgan Stanley of New York at $22 billion and 19 others.
“Most swaps are negotiated with the investment bank that does the underwriting,” Fuller said. “It’s unusual that an issuer would use a counterparty other than the underwriting investment bank.”
Dealers Flee
For almost two decades, auction-rate bonds allowed local governments, hospitals, and closed-end mutual funds to issue debt maturing in as long as 40 years at short-term rates that reset every 7, 28 or 35 days through bidding.
Investors and dealers began to abandon the market in February on concern that the creditworthiness of companies insuring the bonds was deteriorating because of their losses from guaranteeing debt backed by subprime mortgages.
More than two-thirds of auctions failed, data compiled by Bloomberg show, and the average rate on seven-day securities rose to 6.89 percent on Feb. 20 from 3.63 percent a month earlier, according to the Securities Industry and Financial Markets Association. When an auction fails because sellers’ orders overwhelm demand from bidders, rates are set at a predetermined “penalty” level.
Municipal issuers have replaced or announced plans to refinance more than $63 billion of auction-rate debt, according to Bloomberg data.
New Problem
Because most borrowers entered into swaps where they agreed to make a fixed payment in exchange for variable payments from the banks arranging the transaction, they now have to fix the contracts, said Jeff Pearsall, a managing director at Philadelphia-based Public Financial Management, the largest adviser to U.S. municipalities.
“We’re spending the bulk of our time fixing broken, insured auction-rate bonds, many of which have swaps attached,” Pearsall said. “It tends to raise their cost of capital.”
A swap is a type of derivative, or financial instrument derived from stocks, bonds, loans, currencies or commodities, or linked to specific events like changes in interest rates or the weather. In a swap, parties exchange payments based on a specified amount of debt.
Interest-Rate Swaps
For issuers of auction-rate bonds, the variable rates they received, based on the London interbank offered rate, roughly matched the cost of auction-rate bonds for more than five years. The relationship broke down this year as rates on auction-rate bonds soared and Libor fell.
“In many cases they’ve had years of savings that are now being taken back in part or in whole,” said Peter Shapiro, managing director of Swap Financial Group, a South Orange, New Jersey-based financial adviser to state and local governments.
Redding, California, expects to pay Citigroup $6.7 million to close out a swap on $67.3 million of auction-rate bonds it sold, said Tom Graves, financial manager of the city’s electric system, the recipient of the proceeds.
It refinanced the bonds on April 28, selling fixed-rate debt because it was concerned variable rates in the municipal market might shoot up again, he said. Danielle Romero-Apsilos, a spokeswoman for Citigroup, declined to comment.
`Very Good Alternative’
“It was a very good alternative while it worked,” Graves said in reference to the use of auction bonds combined with fixed-rate swaps. “Our feeling was that there was still uncertainty in the marketplace that hadn’t been resolved.”
Sacramento County did a swap with Morgan Stanley in conjunction with a sale of $79.5 million in auction-rate securities for its airport in May 2006. The contract was to last until the bonds, which were insured by New York-based XL Capital Assurance Inc., matured in 2024.
The county agreed to pay the bank a fixed rate of 3.785 percent in return for a variable payment that was supposed to cover the cost of the bonds. The rate it received from Morgan Stanley was capped at 65 percent of the one-month Libor, which averaged 5.08 percent that month.
Sacramento County paid an annualized rate that reached 9.8 percent at a monthly auction of $39.7 million of its bonds on March 11. The county received a variable rate of about 2 percent from Morgan Stanley, according to the bond documents. Jennifer Sala, a Morgan Stanley spokeswoman, declined to comment.
Wisconsin Public Power
Wisconsin Public Power Inc. in Sun Prairie spent about $11 million to terminate swaps on $192 million of tax-exempt auction-rate bonds it refinanced on April 21, according to a Standard & Poor’s report. Marty Dreischmeier, the company’s chief financial officer, didn’t return calls for comment. The swaps were done with Bear Stearns Cos. and JPMorgan Chase & Co., both based in New York, S&P said.
CareGroup Inc., a hospital system based in Boston, plans to borrow $371.1 million to refinance auction bonds and terminate interest rate swaps with Citigroup and Bank of America Corp. of Charlotte, North Carolina, at an estimated cost of $12 million, according to reports from Standard & Poor’s. CareGroup’s spokesman Jerry Berger confirmed the information from the reports and declined to elaborate.
Bentley College in Waltham, Massachusetts is preparing to terminate swaps on $56 million in auction-rate bonds that it’s refinancing, said Paul Clemente, the CFO. The penalty changes daily depending on interest rates, and Clemente declined to speculate on the final cost. The swap was arranged by Lehman Brothers Holdings Inc. in New York and Bank of America.
“It’s probably going to cost us something,” Clemente said. “These are the risks of getting into interest-rate swaps.”
http://www.bloomberg.com/apps/news?pid=20601109&sid=arigOxlIiRm4&refer=home
Auction Wreck Drives Borrowers to Protect `Good Name’ (Update1)
By William Selway and Jeremy R. Cooke
May 12 (Bloomberg) — Local governments and mutual fund managers who suffered the least from the collapse of the auction- rate bond market are refinancing securities rather than risk losing the confidence of their investors.
The Southern California Public Power Authority sold $48 million of bonds on May 7 to buy back auction-rate debt paying 4.01 percent, little changed from the 3.95 percent before the market unraveled in February. John Hancock Financial Services Inc., the mutual fund unit of Toronto-based Manulife Financial Corp., said it will repurchase $1.6 billion of the securities.
States, cities and hospitals have taken steps to replace $63 billion, or 38 percent, of the debt, after failed auctions saddled borrowers with rates as high as 20 percent and left investors unable to get their money, according to data compiled by Bloomberg. Now, some of the borrowers that avoided double- digit rates are joining the exodus to relieve investors they may need for debt financing.
“We wanted to maintain our good name,” Southern California Public Power finance manager Craig Koehler said.
John Hancock said May 7 that five of its funds will buy back auction-rate preferred shares from investors frozen by the market’s “unprecedented illiquidity.”
`Ultimate Answer’
When auctions, typically held every seven, 28 or 35 days, fail to draw enough buyers, rates get set at a level specified in bond documents, or one based on a formula pegged to money-market benchmarks. The $330 billion market, which also includes mutual fund firms and student-loan companies, fell apart when investors shunned the securities and dealers stopped buying bonds that went unsold.
Failures totaled 73 percent of last week’s 2,557 auctions, according to Bloomberg data.
“We are actively working with the issuers of these securities to refinance them, which is the ultimate answer,” Merrill Lynch & Co. Chief Executive Officer John Thain said in comments to reporters in Mumbai on May 7. New York-based Merrill was the seventh-largest underwriter of auction-rate debt between 2000 and 2007, according to Thomson Reuters.
The Southern California Public Power Authority wasn’t squeezed by higher costs because its penalty rate was capped by a formula. The Pasadena-based agency, which raises money on behalf of 10 municipal utilities and one irrigation district, obtained yields of 2.03 percent to 4.49 percent on the fixed-rate bonds it sold last week, with maturities ranging from one to 14 years.
“As I talk to most other issuers, they say they’re unwinding their programs too,” Koehler said.
$40 Billion Coming
Borrowers may sell an additional $40 billion in tax-exempt fixed-rate bonds to get out of auction-rate debt by year-end, with most expected in the next three months, according to Peter DeGroot, a municipal strategist at Lehman Brothers Holdings Inc. in New York.
Issuers refinancing and bidding on their own debt have lowered borrowing costs on auction-rate bonds. The Securities Industry and Financial Markets Association index of securities that reset at weekly auctions fell to 4.17 percent on April 30 from a record 6.89 percent on February 20. The average rate was 3.65 percent last year.
“The problems that have beset the municipal market for the past six months have not been resolved, but they are more quantifiable,” DeGroot wrote in a May 7 report. The auction-rate securities market “is being refinanced rapidly, with most product expected to be placed by end-July,” he said.
Florida Hospital
This week, Memorial Healthcare System, based in southern Broward County, Florida, will sell $160 million of bonds to permanently replace auction debt issued in 2003 and 2004. The hospital district had tapped a Bank of America Corp. loan to redeem the securities the past two months. UBS AG will manage the bond offering.
Failures have been most acute in the market for so-called auction-rate preferred shares, which are sold by mutual funds, and debt sold by student loan providers. The failure rate for those securities was about 99 percent last week, according to Bloomberg data.
Unlike many of the municipal bonds that were refinanced, closed-end shares and student-loan debt have penalty rates that are typically pegged to money markets, providing less compensation for investors stuck with bonds they can’t sell.
At least $14 billion of auction-rate preferred shares have been announced for redemption or refinancing since the market collapsed.
http://www.bloomberg.com/apps/news?pid=20601087&sid=agdA6QUanHH0&refer=home
Wachovia’s Auction-Rate Securities
Are Probed by U.S., State Regulators
By BHATTIPROLU MURTI
May 12, 2008 10:53 a.m.
Wachovia Corp. confirmed that its Wachovia Securities LLC and other affiliates received inquiries and subpoenas from the Securities and Exchange Commission and several state regulators regarding auction-rate securities.
The financial services firm said the regulators are seeking information concerning the underwriting, sale and subsequent auctions of municipal auction-rate securities and auction-rate preferred securities.
“Further review and inquiry is anticipated by the regulatory authorities and Wachovia will cooperate fully,” the company said in its quarterly report with the SEC.
Also, Wachovia and Wachovia Securities were named in a lawsuit in New York. The lawsuit seeks class-action status for customers who bought and continue to hold auction-rate securities based upon alleged misrepresentations made with respect to the quality, risk and characteristics of the securities.
The bond market for auction-rate securities has recently experienced significant difficulties caused by decreased demand, failed auctions, unusual interest rates and other challenges.
Auction-rate debt carries yields similar to long-term debt but acts like short-term investments because investors can sell at weekly or monthly auctions, when rates reset. The $330 billion market was used a lot by municipalities to borrow money, but it collapsed earlier this year.
New York’s attorney general and securities regulators in several states are conducting a broad investigation of the auction-rate securities and the role played by Wall Street firms in promoting and marketing these to investors.
Separately, Wachovia said Jane Sherburne will succeed retiring Mark Treanor as general counsel later this summer.
http://online.wsj.com/article/SB121060269753685269.html
Google Gets Bitten By The Auction Rate Securities Bug (GOOG)
Peter Kafka | May 13, 2008 9:00 AM
We missed this the first couple times we looked at Google’s 10-Q, but Lehman’s Doug Anmuth picked up on it: Google is holding $259.6 million worth of “auction rate securities”, and like everyone else who owns these things, doesn’t really know what, if anything they’re worth.
Obviously this is a non-issue for Google (GOOG): That $260 million is about 2% of Google’s $12.1 billion cash hoard, or about 20% of Google’s net profit for the last quarter. Even if it had to wipe the entire thing off its books, it would have plenty left to invest in money-burning businesses.
The bigger issue is for other tech companies, public and private, that may still be trying to grapple with the auction rate problem. This is the first time that Google has disclosed its auction rate investments, which are bonds that were sold as “cash on steroids” but have since imploded. So we imagine we’ll see other companies making similar announcements.
Earlier this spring our contributor Sarah Lacy surveyed her pals in the Valley and said that the panic over auction rates was overblown, and that smart startups avoided these things and weren’t cash-strapped to begin with. Other folks we’ve talked to think the problem may be more serious. We hope they’re wrong and Sarah’s right.
http://www.alleyinsider.com/2008/5/google_gets_bitten_by_the_auction_rate_securities_bug_goog_
JPMorgan May Be Charged over Muni Bonds
It says the SEC is considering a civil complaint related to bidding that involves the bank’s securities division.
http://www.cfo.com/article.cfm/11367246
Auction-Rate Collapse Costs Taxpayers $1.65 Billion (Update3)
By Michael Quint and Darrell Preston
May 16 (Bloomberg) — In 2003, the Culinary Institute of America outgrew a former Jesuit seminary building on its Hyde Park, New York, campus. So it asked Edward Shapoff, a Goldman Sachs Group Inc. banker on its finance committee, for advice on borrowing to pay for new housing and parking.
Shapoff recommended auction-rate bonds, securities that pay short-term interest rates yet don’t come due for as long as 40 years.
“The advice seemed quite reasonable,” said Charles O’Mara, the institute’s chief financial officer, who arranged three auction-rate bond sales totaling $56.8 million.
For about three years, the school’s weekly auctions cost the institute as little as 0.7 percent. Then, in September 2007, rates began to rise when investors saw auctions of other debt fail to attract buyers and they grew concerned that bond insurers might be laid low by the subprime-mortgage contagion. By Feb. 19, after dealers halted a two-decade practice of buying bonds that didn’t sell at auctions, the institute’s rate peaked at 14 percent. Over the next 12 weeks, it paid $561,000 more in interest than it had in the previous 12.
“Auction bonds had been around in the municipal market for 10 or 12 years and had worked well,” O’Mara said. “Nobody knew then that bond insurers would plunge into subprime mortgages or banks would stop their support.”
$1.65 Billion
The Culinary Institute is among hundreds of borrowers facing an unexpected rise in financing costs. Across the country, local governments and operators of hospitals and schools that issued about $166 billion of auction-rate bonds — about half of all such securities — have paid an estimated $1.65 billion in additional interest since the market soured in September, according to data compiled by Bloomberg.
That money comes right out of the pockets of taxpayers, from New York to California, and organizations such as the Culinary Institute that are allowed to borrow in the municipal market.
Auction-rate securities, which increased to $330 billion over 24 years, are marked by a history of secrecy and dealer manipulation of borrowers and investors, according to U.S. Securities and Exchange Commission documents.
“Proponents of auction bonds downplayed the risks for issuers and buyers, first by not talking about earlier problems, and then managing auctions to keep rates at levels that pleased everybody, at least for a while,” said Joseph Fichera, chief executive officer of New York-based Saber Partners, which advises governments in their negotiations with banks.
Billions in Fees
Rates on the bonds are determined by bidding typically every 7, 28 or 35 days. If buyers are scarce, the auction fails and some bondholders who wanted to sell are left holding the securities. The issuer gets stuck with a penalty rate.
For investment banks, the bonds generated more than $1 billion in fees at the initial sale. They also received annual payments for handling the auctions of a quarter percentage point, or about $825 million a year based on the $330 billion outstanding before the collapse.
Bankers earned additional, undisclosed profit from arranging swaps intended to convert the variable interest rate on an auction bond to a fixed one. Culinary Institute, for example, expected the combination of auction-rate bonds and swaps to result in fixed borrowing costs of 3.36 percent to 3.68 percent on its three sales, less than O’Mara says it would have paid for ordinary fixed-rate bonds.
Wrong-Way Swaps
Most borrowers also entered into swaps where they agreed to make a fixed payment in exchange for variable payments from the banks arranging the transaction, according to Jeff Pearsall, a managing director at Philadelphia-based Public Financial Management, the largest adviser to U.S. municipalities.
For issuers, the variable rates they received, based on the London interbank offered rate, or Libor, roughly matched the cost of the bonds for more than five years. The relationship broke down this year as the bond rates soared and Libor fell.
“We’re spending the bulk of our time fixing broken, insured auction bonds, many of which have swaps attached,” Pearsall said. “It tends to raise their cost of capital.”
After the market collapsed in February, the interest cost on New Jersey’s $3.4 billion of auction-rate debt increased by $2 million a week, forcing the state to spend $17 million to convert it to other kinds of debt. Hospitals, athletic stadiums and other state and local borrowers saw monthly debt service rise.
Ignoring Risk
The combination of short-term borrowing costs and long-term debt also appealed to other issuers, such as student-loan agencies and closed-end mutual funds.
Investors ranging from Fortune 500 companies to individuals collected higher yields than they would have received from money-market funds or Treasuries, and ignored or were ignorant of the risk that they couldn’t easily sell their investments if auctions failed. Many, like William Kannall, got caught with securities they couldn’t unload when the market broke down.
Kannall, 64, who invested $500,000 in auction-rate securities in December 2007, learned in February that he couldn’t get access to his money, which he needs for living expenses and to treat a disease that suppresses his immune system. The Spokane, Washington, resident said he has filed a complaint with the Financial Industry Regulatory Authority against the dealer who sold him the securities, A.G. Edwards Inc., now part of Wachovia Corp. Justin Gioia, a Wachovia spokesman, declined to comment on the case.
“The brokers created and manipulated this market,” Kannall said. “My broker told me A.G. Edwards always buys these and that they’re safe.”
Failed Auctions
With auction-rate bonds, Wall Street firms had a product they could sell to corporate cash managers for a fee as much as four times greater than what they collected for alternatives. They also offered investors more yield than Treasury bills or money-market mutual funds.
Everyone was happy until the market collapsed when credit- market losses raised concerns that MBIA Inc. and Ambac Financial Group Inc., the two largest insurers in the auction-rate market, might lose their AAA ratings. Banks stopped bidding at auctions for their own accounts while they were absorbing more than $320 billion of losses on subprime mortgages.
By mid-February, Citigroup Inc., the largest underwriter of auction-rate bonds, held $11 billion of them, up from $8.1 billion at the end of 2007, the bank said when it reported a $5.1 billion loss for the quarter ended March 31.
Penalty Rates
Thousands of auctions failed, forcing issuers such as the Port Authority of New York & New Jersey to pay interest rates as high as 20 percent. The investors were left with securities they couldn’t sell.
Holders with no immediate need to unload their auction debt have benefited from the rise in yields. The 3.89 percent average for municipal auction bonds with weekly bidding on May 7 is higher than the 2.33 percent for variable-rate demand bonds and the 2.28 percent yield for Vanguard’s $22.8 billion Tax-Exempt Money Market Fund. Jefferson County is paying 7.96 percent on its failed auction debt.
Investors bought the bonds seeking higher yields for money they wanted invested short-term, said Eduard Korsinsky, an attorney with the New York law firm of Levi & Korsinsky, which represents investors in lawsuits. They thought they would have quick access to the money because the securities were highly rated and often insured, he said.
“This is something Wall Street foisted on an unsuspecting public,” Korsinsky said.
Suits Filed
Now, hundreds of individuals have filed lawsuits with Finra, saying they were misled about the safety of auction-rate securities. Some have seen the value of their investments decline as dealers who sold the bonds then wrote them down.
The Securities Industry and Financial Markets Association, which represents 650 securities dealers, defends the sellers’ actions.
“For 20 years the auction-rate market has met the needs of issuers and investors,” said Leslie Norwood, managing director and associate general counsel for the group. The failure of the market “was completely unexpected, like a dam break,” she said.
Father of the Bond
American Express Co. sold the first auction-rate securities in 1984, with a $350 million issue of money-market preferred shares with dividends reset at auction every 49 days. At that time, “the minimum purchase was $500,000, and buyers were treasurers of very large companies,” said Ronald Gallatin, the former Lehman Brothers Holdings Inc. managing director who invented the securities.
Other banks copied Gallatin’s idea, leading to sales by companies ranging from Citicorp, then the largest U.S. bank, to MCorp, a Dallas bank holding company that later collapsed.
The first unsuccessful auction occurred in 1987, when investors avoided auctions of MCorp’s $62.5 million issue. Many corporate borrowers and banks, including Citicorp, now Citigroup, and Chase Manhattan Corp., now JPMorgan Chase & Co., turned their backs on the concept in the 1990s and retired the securities after interest rates exceeded 13 percent.
From the beginning, banks were manipulating the market. In 1995, investors learned that Lehman settled allegations by the SEC that it improperly bid at some American Express auctions. Lehman, which the SEC said manipulated bids 13 times and prevented two auctions from failing, paid an $850,000 fine without admitting or denying wrongdoing.
Willing to Risk
The first tax-exempt auction-rate security was sold by Arizona-based Tucson Electric Power Co., now part of Unisource Energy Corp., in 1988. The utility’s $121 million of bonds qualified for tax-free financing because they funded pollution- control equipment.
The deal worked because Goldman was expected to buy securities to ensure the auctions’ success, said Susan Wallach, Tucson Electric’s treasurer.
“No one ever questioned the banks’ liquidity,” she said. “People were willing to take the credit risk.”
In 1990, when Tucson Electric began losing money and its credit rating plunged, rates on the auction bonds rose to 12.6 percent. Investors soon found funds frozen because there weren’t enough bidders. Bear Stearns & Co. was brought in to manage the auctions and convert the debt to bonds with a fixed rate of 7.25 percent.
Municipal Explosion
The market took off after 2000, with sales of municipal auction-rate bonds exploding from $9.56 billion a year to more than $40 billion in 2003 and 2004, according to Thomson Reuters.
To avert failed auctions, bankers encouraged municipal issuers to insure bonds, bringing top ratings and investor confidence. Insurance promised investors they would receive principal and interest, not that they would be able to sell when they wanted, said Robert Fuller, principal at Capital Markets Management, a Hopewell, New Jersey-based financial adviser.
“There was a misconception in the municipal market that the AAA ratings of bond insurers would create liquidity,” Fuller said.
Auction-rate bonds proved popular enough that they usually sold at yields lower than variable-rate demand bonds, or municipal debt that allows investors to seek repayment from a designated bank even if the dealer handling the bonds can’t find buyers.
New York Study
A study by the state of New York for the two years ended in September 2007 found that the average interest rate on its $4 billion of auction-rate bonds was 3.16 percent, or 0.27 percentage point below the 3.43 percent for its $4.2 billion of variable-rate demand bonds. The rate was also below the 4.41 percent average during the period on the Bond Buyer 20 index, a gauge of costs on long-term, fixed-rate municipal debt.
O’Mara of the Culinary Institute said costs on the interest-rate swaps and auction bonds it plans to replace with other variable-rate debt were less than if it had sold fixed- rate bonds in 2004 and 2006.
Because there is no bank guarantee of repayment, auction- rate issuers should pay more, not less, Saber’s Fichera said.
The SEC began investigating alleged manipulation in the market in 2004. It asked dealers to review and report on how they conducted auctions. In the following years, auction-rate municipal bond sales fell to about $30 billion.
SEC Fines
In May 2006, the commission fined 15 dealers $13 million for manipulating the market, though the dealers didn’t admit or deny wrongdoing. Rather than forcing them to abandon practices that had become standard, the SEC said the practices could continue as long as they were disclosed.
Norwood of the dealers’ association denied that the market was manipulated. The 2006 SEC action was an example of market regulation and led to even more disclosure, she said.
The SEC action didn’t appease Wisconsin’s debt director, Frank Hoadley, who warned securities dealers in July 2006 to stop manipulating auctions. He said the term “auction” was inaccurate because dealers controlled all information and influenced bids. The association didn’t heed his call for greater disclosure.
“There were a whole bunch of things that just didn’t happen,” Hoadley said.
The SEC was so unconcerned about possible failures that its list of material events requiring disclosure never included unsuccessful auctions.
`Collapse and Fail’
“I don’t think the SEC ever envisioned that a market would just collapse and fail,” said Daniel Johnson, managing partner at Chicago-based law firm Chapman & Cutler LLP and former head of its public finance group. “The focus in the past was on events that related to the underlying borrower,” not the market in which the bonds are traded, he said.
Now, the commission is preparing rule changes to require additional disclosure, including information on the number and size of bids, Martha Haines, head of the SEC’s municipal division, said at a meeting of government finance officials in Albany in April.
“Investors and issuers need to know where the liquidity is coming from,” Fichera said. “Is the auction one where there are only five bids and the bank is always buying for its own account? Or are there 175 bidders, and the bank rarely helps?”
If those disclosures had been in place sooner, “it might have limited the size of the auction-rate market to one that was sustainable,” Haines said.
The lead-up to February’s meltdown began in July, when MBIA and Ambac reported lower profits because of losses on securities backed by subprime mortgages. In August, insurers’ subprime losses led to $1.8 billion of failed auctions for their own securities, according to Fitch Ratings.
`Guilt by Association’
By September, as word of those auctions spread, yields of auction-rate securities for municipal borrowers rose above those of variable-rate bonds. George Friedlander, a Citigroup analyst, blamed higher rates on “guilt by association” with unsuccessful auctions in the taxable market, where securities issued by subprime-tainted collateralized debt obligations had gone bust.
“Investors are nervous that if there aren’t enough buyers at the auctions, they have to rely on bids by dealers and might have to hold the bonds,” said Richard Davis, assistant commissioner at the Utah Board of Regents, which began issuing the bonds in 1998.
Corporate investors started unloading auction-rate investments in the last half of 2007. By Jan. 1, they had sold off $70 billion, cutting holdings to $100 billion in six months, according to Treasury Strategies, a Chicago-based adviser to corporate treasurers.
Synaptics Stuck
Not everyone could sell. Synaptics Inc., a Santa Clara, California-based maker of touch pads for digital music players and electronic devices, in September revealed holdings of auction-rate bonds it couldn’t dispose of. It was followed by other companies, from Silicon Valley startups to industry giants such as New York-based Bristol-Myers Squibb Co., which reported a $275 million loss on $811 million in investments in auction- rate securities, according to its earnings report for the last quarter of 2007.
At the same time, yields climbed. In November, the seven- day average rate for municipal auction-rate bonds reached 4.03 percent, almost half a percentage point higher than variable- rate demand bonds.
The market broke down the week of Feb. 13, as banks let dozens of auctions fall through. More than 60 percent of the thousands of auctions conducted each month have failed since then, Bloomberg data show. Interest rates on municipal bonds that come up for auction weekly rose to an average of 6.89 percent the week of Feb. 20, up from the average of 3.65 percent for 2007.
`We Are Not Happy’
The banks’ decision to stop supporting auctions reminded investors and issuers “that when push comes to shove, the banks will do what’s best for their shareholders,” the SEC’s Haines said.
New York Attorney General Andrew Cuomo has issued subpoenas to at least 18 banks, including Merrill Lynch & Co., UBS AG and JPMorgan, seeking information about how they persuaded issuers to sell the bonds and how they decided to curb their bidding at auctions, a person familiar with the investigation said. Cuomo, along with a Massachusetts-led task force of nine other states, the SEC and Finra, which oversees brokerages, are examining dealer disclosures.
“We are not happy with the way investment banks have performed,” said David Brown, former executive director of the New York State Dormitory Authority, which issued $1.3 billion of auction-rate bonds for hospitals and private colleges, including the Culinary Institute, and $1.2 billion for the state. “This was a product sold to a lot of borrowers as being appropriate.”
The Market’s Future
Many issuers are getting out of auction-rate debt and say they will never use it again. State and local governments have already replaced or announced plans to replace at least $68 billion of the securities, according to Bloomberg data. Many are switching to variable-rate demand bonds, whose 2.25 percent average in the past month is about half the 4.56 percent for auction-rate bonds. Others are stuck, unable to issue new debt. Some investment banks, including Citigroup, say the market will never come back.
“It’s a damaged product, and I can’t imagine issuers using it again,” said Wisconsin’s Hoadley. “A lot of people will have to die and institutional memory go away before people will come back to it.”
Too Late?
The Municipal Securities Rulemaking Board and Sifma have put together proposals to address some of the complaints Hoadley and others made about the lack of transparency. The MSRB advised creating a Web site to disclose more information on auction results.
“I hope it’s not too late,” the SEC’s Haines said.
Gallatin, the father of auction-rate securities, doesn’t hold out much hope. He expects auction-rate bonds will be replaced by other debt because too many investors and issuers lack confidence.
“The back of the market is broken,” he said. “I think the market’s problem started with credit, but now credit isn’t the problem.”
http://www.bloomberg.com/apps/news?pid=20601109&sid=aJqqPcSJQGXg&refer=home
Auction Failure Damages Face Burden of Proof Eluding Lawyers
By Thom Weidlich
May 27 (Bloomberg) — Lawyers who sued broker-dealers, including Citigroup Inc. and Morgan Stanley, for steering investors to the now-failing $330 billion market for auction-rate securities may be unable to prove their clients lost money or collect fees for themselves.
At least 24 proposed class actions have been filed since mid-March against brokerages over claims investors were told the securities were almost as liquid as cash. Auctions for the investments, typically municipal and student-loan-backed bonds and preferred shares, have been failing since mid-February, leaving investors unable to sell their securities.
Even so, investors continue to make money, corporate defense lawyers not involved in the cases point out. The interest –reset every 7 to 35 days at bidding managed by the dealers –gets raised to a higher penalty rate, sometimes as much as 20 percent, when auctions fail.
“I don’t see how you get around the fact that, for the most part, the investors are doing better,” said David Gourevitch, a former U.S. Securities and Exchange Commission lawyer now practicing in New York who isn’t involved in the lawsuits.
The existence of the penalty reset rate proves investors knew the auctions might fail, said Daniel J. Tyukody, a partner at Orrick, Herrington & Sutcliffe in Los Angeles who isn’t involved in the cases.
The investors’ lawyers argue that clients were damaged because they couldn’t use their money for other purposes.
John Coffee, a Columbia University securities law professor, said there are “some problems” with that claim. “I don’t know that you can easily measure the loss of liquidity,” he said.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aebfo_FTFQk0&refer=home
Auction-Rate Securities Give Firms Grief
Companies Struggle to Come to Terms
With Writing Down Troubled Holdings
By LIZ RAPPAPORT
May 27, 2008; Page C1
The credit crisis is receding, but hundreds of U.S. companies still are struggling to clean up the problems caused by auction-rate securities.
A review of first-quarter earnings reports showed that more than 400 companies, including Google Inc., Bed Bath & Beyond Inc. and Starbucks Corp., held at least $30 billion in the securities, instruments they once thought were as dependable as cash.
Some companies have had to scramble for funds in the months since the market froze up in February. The securities also are creating an accounting problem for businesses not used to pricing complicated securities. While some companies have written down the value of their auction-rate holdings, many others haven’t, even though market prices have fallen substantially.
http://online.wsj.com/article/SB121185073143321559.html
Another Firm Gets Tangled in ARS Web
First Southwest settles with SEC after regulator claims that company intervened in auctions without adequately disclosing its positions.
Stephen Taub
CFO.com | US
May 28, 2008
A Texas broker-dealer has agreed to settle Securities and Exchange Commission charges related to its practices in the auction rate securities market during 2003 and 2004. Dallas-based First Southwest Co., without admitting or denying the findings in the SEC administrative proceeding, consented to the entry of an cease-and-desist order providing for a censure and a $150,000 penalty.
The SEC claims that between January 2003 and June 2004, First Southwest, without adequate disclosure, intervened in auctions by bidding for its proprietary account to prevent failed auctions and to prevent all-hold auctions (when all current holders decide to hold their securities without specifying a minimum rate). In those alleged instances when these practices affected the clearing rate of an auction, investors received a lower or higher rate of return on their investments, the SEC explained.
“To the extent that these practices affected the clearing rate, investors may not have been aware of the liquidity and credit risks associated with certain securities,” said the SEC order. The regulator said that by engaging in such practices, First Southwest purportedly violated rules that prohibit material misstatements and omissions in any offer or sale of securities.
“First Southwest Company is committed to ensuring that our auction rate practices meet the highest industry standards and that the firm is in compliance with SIFMA’s Best Practices for Broker-Dealers of Auction Rate Securities,” CEO Hill Feinberg, told CFO.com. “We have always supported the efforts of the Securities Exchange Commission to improve disclosure in capital markets and are pleased to have this matter resolved,” added Feinberg.
The commission emphasized that in determining the size of the penalty, it considered First Southwest’s cooperation and its relatively small share of the auction rate securities markets. “The Commission, however, also considered that First Southwest did not report its practices to the Commission,” it added.
ARS are municipal bonds, corporate bonds, and preferred stocks with interest rates or dividend yields that are periodically re-set through auctions, typically every 7, 14, 28, or 35 days. Auction rate bonds are usually issued with maturities of 30 years, but the maturities can range from 5 years to perpetuity.
ARS are often marketed to issuers as an alternative variable rate financing vehicle, and to investors as an alternative to money market funds. First developed in 1984, the ARS market has grown to well over $200 billion. Essentially, ARS are long-term investments typically marketed as alternatives to cash since their interest rates are reset at short-term intervals. Also, investors can choose to sell the securities. However, earlier this years a number of auctions failed due to the global credit crisis, forcing many investors to hold on to the securities, which have become illiquid.
In March, Morgan Stanley was sued by a client for “deceptively marketing” ARS as cash alternatives. At the time, the investment bank shot back in a statement saying that, “the challenges of the auction rate markets are industry-wide, and result from broader credit market conditions.”
Then in April, state and federal regulators launched investigations into the ARS market and possible wrongdoing by large investment houses. The main complaint from investors was that brokers sold the securities claiming that ARS were as safe as cash, which “they’re not,” noted New York Attorney General Andrew Cuomo, who subpoenaed 18 banks and securities firms in related probes.
http://www.cfo.com/article.cfm/11443235
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