Friday, February 20, 2009

The Debts of the Spenders: Auction Rate Securities Continue to Haunt Markets

Like a nasty poltergeist, the auction rate security market (or lack of it) continues to haunt investors, issuers, regulators, and other interested parties.

Auction rate securities are bonds or preferred stock that have rates set by reverse auctions. They were frequently issued by parties that wanted to engage in long term financing but take advantage of short term interest rates. Auctions were typically held every 7, 28, or 35 days to reset the interest rates as the securities are passed on to new holders.

Wall Street banks were responsible for soliciting bids so that the securities could be sold successfully at auction. In turn, the banks charged lucrative fees for managing and soliciting the bond auctions. Many banks also decided to hold these assets on their own books as well in order to fatten their bottom lines.

But when the banks realized that liquidity was beginning to dry up (and leaving them w/illiquid "Level 3" assets on their books), they began marketing the same toxic assets as safe, conservative investments to ordinary retail investors. Troubles began to surface in late 2007 and began to rear its head in early 2008 with allegations surfacing against Lehman Brothers and Bear Sterns.

Indeed, it was Lehman Brothers that eventually epitomized the full extent of Wall Street's fraud. But other banks are equally liable: Goldman Sachs, Merrill Lynch, and other hallowed names were involved in the ARS game.

Even after state and federal regulators settled a number of actions against these firms (typically by forcing them to re-buy the auction rate securities back), yields continue to remain low because the Fed's actions to slash interest rates to record lows gives issuers little incentive to refinance. Moreover, the return of the auction rate securities continued to burden the banks with the same problem of illiquid assets on their books that they faced last year.

When times were good these banks were all too happy to keep mark to market value of these assets on their books since they were yielding up to 18-20% interest. But now when the rates are below 2% (at best), the enthusiasm for m2m has waned noticeably.

Bloomberg published a recent update:

“I have lost all faith in bankers and Wall Street,” said Stelzer, who invested the proceeds from the sale of his ranch in the securities through San Francisco-based Wells Fargo & Co.

A year after collapsing, the one-time $330 billion market for debt with rates typically set every 7, 28 or 35 days is still claiming victims. Investors are stuck with as much as $176 billion of the securities even after regulators forced banks to buy back more than $50 billion of auction-rate debt that was marketed as safe, cash-like instruments.

The market’s meltdown, the result of the seizure in credit markets, initially left investors with bonds they couldn’t sell, though the securities paid interest at rates as high as 20 percent. Now, rates on securities auctioned every seven days pay an average 1.36 percent, according to an index from the Securities Industry and Financial Markets Association, after central banks slashed borrowing costs.

Investors are stuck because interest on auction-rate securities is lower than what issuers would have to pay on new borrowings, giving them little incentive to refinance.

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