Auction-Rate Securities, RIP?

Includes: BSV, GBF, MUB, TFI
by: Felix Salmon

Do auction-rate securities have a future? I'm not sure myself, so I put a couple of questions to Floyd Newton, a partner in King & Spalding's finance practice. Floyd has a long history in the auction-rate market, and seems to know what he's talking about.

My first question was whether the new electronic trading platform being launched by Restricted Stock Partners is likely to help bring liquidity back to the market. Floyd says no:

I do not believe that this imitative will have any effect on the secondary market for auction-rate securities. These securities are readily available from the existing broker-dealers, and I am not aware of any reason why having an electronic trading platform from this company would have a positive impact on this market. The principal issues in this market are simply a lack of investor confidence in this market. When auctions begin to fail, for whatever reason, it creates a "panic," where investors rush to get out unless the broker-dealers act to stabilize the market, and at the present, they are not able to do this.

My second question was whether John Carney is right when he says that auction-rate securities never had much of a market to begin with, and were always supported by the broker-dealers. Floyd's unsure about that as well:

This is a more complicated question. First, I am not sure that I agree that the auction market "never had enough buyer demand" to support itself. I doubt that this market would have gotten to this size if there were not buyers out there demanding this product, at least until they became concerned about their liquidity. Stabilization is a different issue. There is nothing wrong with stabilization to protect the market and produce more uniform results. Where the buyers lose confidence in the market in a short time period and there is a "rush" to the door by the investors, it is not surprising that the broker-dealers are not willing to "stabilize" the market.
Going forward, I suspect that this market will not exist in its present form. Investors in this type of security are very concerned about their liquidity, and with the liquidity of these investments now in question, it is unlikely that they will return in volumes needed to support this market.

Overall, then, it seems that the market used to be healthy, once upon a time, but that it's now a thing of the past - and nothing, not even a swanky new electronic trading platform, is likely to save it.