Retail Investors Stuck Holding Auction Rate Securities

Gretchen Morgenson’s “It’s a Long, Cold, Cashless Siege” in The New York Times excels at explaining the transition of auction rate securities [ARS] from corporate to individual investor hands. ARS started as preferred shares issued by American Express (AXP). Other financial institutions followed until the Federal Reserve disallowed ARS to be counted as permanent capital. ARS were popular because they paid up to 1% more than money market funds and CDs. During the second half of 2007, corporations sensed trouble and started bailing out. Simultaneously, retail brokers started pushing ARS on individual investors. By the end of 2007, retail investors held 70% of the $330B ARS market. The minimum investment dropped to $25,000. Typical ARS retail investors hold $200K to $300K.

Previously I wrote that "Auction Rate Bonds are not Cash Equivalents" and described the "Mechanics of Auction Rate Securities". The NYT reiterated that auction rate bonds mature in 30 years and auction rate preferreds are perpetual.

The top municipal underwriters were Citigroup (C), UBS (UBS), Merrill Lynch (MER) and Morgan Stanley (MS). The current market consists mainly of closed-end mutual funds and municipals. The investment banks charged 1.5% at issue and 0.25% per year to hold the auctions. In addition, they sold interest rate swaps to municipalities. This made the ARS difficult to unwind.

Gretchen’s major surprise was that the auctions were not actually auctions at all. Until February, the issuing investment bank acted more like a market maker than an auctioneer. The sheer number of weekly auctions became overwhelming. They used their own capital to smooth the process. Then their capital became too precious.

The retail investors claim that their brokers did not disclose the liquidity risk in ARS. It appears to me to be a more subtle deception, along the lines of “enhanced” and “government” money market funds. Charles Schwab (SCHW) enhanced its fund with higher risk securities to give a slightly higher yield. I have read the prospectuses of many government funds, only to find they contained no treasuries. Clearly defined was that government includes Fannie Mae (FNM), Freddie Mac (FRE) and the Home Loan Banks, among other things.

Contrary to the alarm about the Port Authority of NY and NJ paying extraordinary high interest rates when their auctions failed, most penalty rates are low. The penalty rates might only be slightly higher than LIBOR (London Interbank Offering Rate). The investor collects the penalty rate when the auction fails.

UBS must feel some guilt or at least sympathy for its retail customers. While the bank is writing down ARS values in customer accounts, it is letting customers borrow against 100% of the par value. UBS will be charging a “modest” interest rate of LIBOR plus 50 basis points.

Disclosure: Author is long C, FNM, FRE and UBS.

Comments

[ARS victim:]

Nice article. When is someone going to connect the dots and call it what it is "The fraud of the century." We got sucked into ARS as of 10/07, just as ML realized it was short on cash. Not sending any prospectus was a plus. When I finally received one after the auctions were closed I did some research. Everyone of the securities I own is underwritten by ML PLUS each company is really a hedge fund in disguise. They simply dumped their inventory in my account. For my IRA I wanted MM liquidity while I was trading stocks and now I'm a stockholder in hedge funds? I wouldn't touch any brokerage stock for a long time nor will I ever use a financial advisor again. ML has too many conflicts of interest and can not be trusted to protect me. They stupidly screwed their best customers. I don't see them wanting this to go to a class action suit with a jury trial.

2008 Apr 14 12:55 PM

[James Davis:]

Full disclosure: I own 1 of these ARS

There's no question this was , in its final days, a fraudulent market, and a criminal enterprise hosted by the large brokers.

They allowed and encouraged their 'henchmen' aka sales force, to foist these time bombs on unsuspecting customers.

The brokers knew full well these were GUARANTEED to fail, since they were the ones that were about to LET THEM FAIL.

Need to be handled at the criminal level if they refuse to make victims whole.

2008 Apr 14 01:01 PM

[Also Stuck:]

I got stuck in these securities also being put in them by my UBS "financil advisor" or "wealth manager". Have written to my two Michigan Senators and area Representative. Someone like the SEC has to force these brokerage houses or mutual fund managers to "let my money go!" If this whole thing was not fraud at the highest level, I don't know what you would classify it.

Seems to me the closed end mutual funds that have my money should be forced to de-leverage and give us our money back. Most of them are saying they are working on it, but don't want to, or can't hurt their common investors.

How can we ever trust "Wall Street" anymore. All this while normal company pension funds are being abandoned and we are being told to invest in 401Ks and IRAs for our retirement. And now they hold our money. Sad.

2008 Apr 14 04:54 PM

[ARS victim:]

Blackrock is one of my ARS holdings. They're not working very hard to refinance but they've just raised 10.9 billion to go into a vulture venture in real estate. That money should have been allocated to deleveraging and getting money back to ARS victims/ Here's the article

www.nytimes.com/2008/0...

2008 Apr 14 05:58 PM

[Serge Birbrair:]

I am looking forward to the next Attorney General willing to throw the Martin Act the brokerage houses and put a few perps in prison.
www.nothingcontroversi...

This is a swindle of the century. Time to clean the house.

2008 Apr 14 09:29 PM

[BK224:]

You're dead wrong. The Auction rate market is comprised of individual security issuers and preferred shares of closed end funds. The auction is a pure dutch auction with the auction agent acting as bidder of last resort. I've worked for 2 significant auction dealers and both fully disclose the possibility of failed auctions in the prospectii and marketing material.

The muni market is working out of this market quite quickly as these securities are being called in now. 50% of the issues my clients have been called. I expect the remaining to be redeemed within 3 months.

The real ramifications are economic in nature due to the lack of access to short term alternatives for money market funds, and of course the lock-up of money waiting to get out.

But mark my words, if there is a 300 Billion market of anything out there, some Wall Street Wizard will create liquidity and get in the middle of it to make alot of money. I hope it's me.

2008 Apr 14 10:01 PM

[Tookit N. L...:]

Despite the language in the prospectus, the brokerage firms and the issuers happily perpetuated an illusion of security and weekly or monthly liquidity through their willingness to act as the bidder of last resort. That was fine while it lasted, but one major problem is that the dealers did not disclose how heavily dependent the auctions were on their participation and the other major problem is that the dealers unilaterally abandoned the market, without warning. In keeping with a time-honored tradition on Wall Street, the retail investors get fleeced. In all fairness, however, there seems to be a fairly large group of institutional investors hamstrung by this mess. Worry not, though, as the dealers will certainly do well as they collect their banking fees for issuing the debt that will hopefully soon be used to refinance the ARS.

2008 Apr 14 10:18 PM

[James Davis:]

As I've stated, there was a conspiracy to

1) Create the illusion of a liquid and fair market, where in fact it was a manipulated , contrived one.

2) Pull support simultaneously, so that no one dealer got stuck holding the bag. Better for the customers to have that privilege.

As for the boilerplate in the 'prospectii' as one poster puts it, no one would buy anything ,ever, if every disclaimer was taken at face value.

Since the dealers so willingly maintained the illusion of liquidity and soundness, let them stand behind their Houdini act for the final bow.

That or face permanent reputational damage for at least a generation.

2008 Apr 15 12:04 AM

[auction stuck:]

here's the thing. I gave strict instructions to my broker. Keep my portfolio looking like its the portfolio of a 98 year old grandmother.
what happened? Im into this auction rate bs to the tune of over a million dollars. Did the financials know the market was going to collapse? sure they did. My guy at citi came out and told me - that the only fair thing to be done - is to have the banks that peddled this stuff - buy it back and deal with the liquidity issues themselves.

UBS really came to the plate and knocked it out of the park - when they decided to loan 100 percent against the shares that an investor holds. What does that say to an individual investor? It says they "get it" - which is more than I can say for most of the financial community.

When will wall street begin to rebuild the trust that they destroyed at their own hands.

When the dust settles, this auction rate problem will make the sub-prime problem look like a joke.

2008 Apr 15 12:25 AM

[Shell Gamed:]

Before you say UBS "gets it", let's see the specifics of this "loan" (lending me back the money they stole, for a fee no less). If this is a permanent loan, with no penalty, maybe.

If this were a major breakthrough, don't you think that UBS would be trumpeting it across the media, especially given the public relations bath they've been taking?

I won't believe them until they show me the money. The last time I trusted UBS, I bought money market instruments and ended up with perpetual bonds.

2008 Apr 15 12:56 AM

[swindled:]

This whole thing is business as usual for the brokers. They fleece the retail investor time and time again. It will never end until the penalties they get hit with hurt more than the money they make fleecing the retail investor. When they get caught and end up paying whatever they pay pales in comparison to what they made mis leading the public. Why would they ever stop if that is the way it works.

2008 Apr 15 01:19 AM

[swindeled:]

Duff and Phelps is the worsat of the close end funds. hey have no intention of willingly looking for alternate financing and will have o be pulled kickign and swcreaming as they profit with their leverage off the backs of sall retail investors that never intended to give them a loan of life. Screw DNP - evryone should stay away from them and Phonenix Investments theire parent they are a cancer.

2008 Apr 15 01:24 PM

[ARS victim:]

A prospectus is only required for the initial public offering. As of the very next auction, the new buyer of the security does not get a prospectus. Part of the problem is that investment houses were allowed to work behind this cloak of secrecy. The financial analyst were given "buy" recommendations by there research department and it was passed on to the customer. Shades of Henry Blodget and the internet boom. I get a prospectus every time I parked cash in ANY MM account, not so with ARS.
I thought my broker, ML, was there to protect me not to con me into buying something they could no longer sell. I was busy following stock picks. I never expected to be blind sided by the fixed income side of my portfolio.

2008 Apr 15 06:20 PM

[Sucker Punched:]

I had never used a financial advisor in my life. Things were busy so I got a recomendation and went with Smith Barney. "Why don't you put it in ARS? Liquid every seven days and you get a better interest rate."


Now I want to use the money and have no access -- Well they sent me some paperwork for a margin account where they can decide the value of the collateral and sell the ARSs if the value falls below the 50% LTV. Not only that but they are the ones deciding what the value of the ARSs is. I'm not that stupid.

On top of that Nuveen is getting ready to buy out 66% of its ARSs and Smith Barney is going to dole them out by lottery not pro rata. Who is gign to win that lottery? Not the little guy. Talk about a loss of reputation.

What's the little guy supposed to do?

2008 Jun 10 09:21 AM

[Sam Spade:]

Do you have any documentation available on the Smith Barney recommendation and, if so, could you share it with me? I am with a P.I. firm that is helping a client prepare for class action litigation and am seeking documentaton on how ARSs were represented to investors.


On Jun 10 09:21 AM Sucker Punched wrote:

> I had never used a financial advisor in my life. Things were busy
> so I got a recomendation and went with Smith Barney. "Why don't
> you put it in ARS? Liquid every seven days and you get a better
> interest rate."
>
>
> Now I want to use the money and have no access -- Well they sent
> me some paperwork for a margin account where they can decide the
> value of the collateral and sell the ARSs if the value falls below
> the 50% LTV. Not only that but they are the ones deciding what the
> value of the ARSs is. I'm not that stupid.
>
> On top of that Nuveen is getting ready to buy out 66% of its ARSs
> and Smith Barney is going to dole them out by lottery not pro rata.
> Who is gign to win that lottery? Not the little guy. Talk about
> a loss of reputation.
>
> What's the little guy supposed to do?

2008 Jul 14 03:00 PM

[Sam Spade:]

Do you have any documentation available what the Smith Barney said and, if so, could you share it with me? I am with a P.I. firm that is helping a client prepare for class action litigation and am seeking documentaton on how ARSs were represented to investors.

On Apr 15 12:25 AM auction stuck wrote:

> here's the thing. I gave strict instructions to my broker. Keep
> my portfolio looking like its the portfolio of a 98 year old grandmother.
>
> what happened? Im into this auction rate bs to the tune of over
> a million dollars. Did the financials know the market was going
> to collapse? sure they did. My guy at citi came out and told me
> - that the only fair thing to be done - is to have the banks that
> peddled this stuff - buy it back and deal with the liquidity issues
> themselves.
>
> UBS really came to the plate and knocked it out of the part - when
> they decided to loan 100 percent against the shares that an investor
> holds. What does that say to an individual investor? It says they
> "get it" - which is more than I can say for most of the financial
> community.
>
> When will wall street begin to rebuild the trust that they destroyed
> at their own hands.
>
> When the dust settles, this auction rate problem will make the sub-prime
> problem look like a joke.
>

2008 Jul 14 03:06 PM

[RIAinJax:]

After reading the posts, my heart goes out to those who bought ARSs. Our firm had a current tax client and prospective investment advisory client call us in the fall of 2007 asking for our thoughts on ARSs which his broker was touting as the greatest thing since sliced bread. Client had a majority of his liquid assets at Merrill and Morgan Keegan, approximately $2.5 million. Familiar with the concept, we spent some time trying to get our hands around individual issues and respective disclosures and in the end didn't find the after tax yield above liquid money funds/sweeps (at that time approximately 2%) to justify the potential for illiquidity. The disclosure of tax treatment of income was in question as well. The $2.5 million went to close on a commercial real estate deal in late Feb 2008 and by that time we had recommended that he exit the ARSs, which he did. We got lucky on the timing. He is now an investment advisory client (we hope life). The morale of the story: you need an advocate advisor you can trust (preferably it be a fee only Registered Investment Advisor) and if it looks too good to be true it usually is.

In addition to fiduciary wealth management solutions, my firm provides expert witness testimony services for financial service litigation.

Adam 904-398-2075

2008 Jul 30 02:05 PM