The Nascent Secondary Market in Auction-Rate Securities

The Restricted Securities Trading Network in auction-rate securities has been up and running now since March, with 7-10 transactions taking place per day. That's not an enormous number of trades, but it's enough to see pretty clearly what the clearing price is that the market puts on these things. And the numbers aren't pretty.

Municipal auction-rate securities trade at a discount of between 0% and 10%; auction-rate preferred securities trade between 10% and 20% below par; and student loan auction-rate securities are changing hands with a discount of 25% and upwards.

When any fixed-income product starts trading in the low 70s, that counts as distressed. And clearly there's a correlation between price and perceived credit risk here. But it's not simply the normal, obvious correlation, where the price simply falls so that the investor can be paid to take on credit risk. Rather, auction-rate securities with non-zero credit risk are the last auction-rate securities that anybody really wants to buy. And if you do buy them, you have no idea when or whether you'll ever be able to sell them. The interest rates might be attractive, but without an exit, you need to be brave indeed to enter this market.

As a result, a small amount of credit risk can have a huge effect on price, and it makes sense for prices to drop to a level where the investor would be comfortable buying a perpetual bond from that issuer. The securities were designed, of course, not to behave as perpetuals but rather to behave almost like cash, with incredibly short maturities. What's more, they were never designed to trade, per se: why would you ever need to sell one on the secondary market, when you can simply not bid at the next auction? The idea that everybody would stop bidding at once didn't seem to occur to the designers.

As a result, the market in these things is thin indeed. If I held a portfolio of them, I wouldn't be particularly happy marking to the RSTN prices, but then again they're probably the closest thing that the market has to public marks, so I might not have much choice.

I also worry about the brokers who put their clients into auction-rate securities, and who until now have at least offered to lend against the "cash-like" investments which have been "temporarily" tied up. If those investments are now trading hands at 80 cents on the dollar or lower, I can't imagine many brokers lending much more than that. Do they still claim to be "scrambling" to solve this problem? I still haven't seen any evidence of that.

Comments

[Serge Birbrair]

The problem of Auction Rate Security market is of the Biblical proportions. $330,000,000,000 are frozen and no end in sight. $330 bils are enough to bail 30+ Bear Stearns, but who will bail us, the bag holders of this misrepresented debacle!?

Here are few things the investors should do:
check ARS victims Action List:
www.nothingcontroversi...

Question EVERYTHING your FA tells you. Never forget, if it wasn't for your Financial Adviser, you would never be in this mess. "Ignorance is bliss" and I am envious toward customers of Fidelity, Scottrade, Vanguard and other firms who hasn't solicited this junk to investors looking for SAFE AND LIQUID cash alternatives.

[billl]

If I could talk to the President.

Mr. President: If you call in the perpetrators of the auction-rate securities mess that is the worst US financial debacle ever (see Dow Jones and New York Times links attached) and jawbone them to unwind the scheme so all funds frozen by them were returned to their rightful owners the US economy will have an instant jump with the return of $330billion of working capital with no cost to taxpayers.

As the situation stands now the perpetrators are arrogant about how cleverly they have lawyered up and can withstand the irate sheep they stuck with this junk. If you offered complete Presidential immunity for all confessed sins and cooperation to fast track fact findings on how the 1999 repeal of Glass-Steagall and the enactment of Gramm-Leach-Blily was used over the last nine years to generate huge profits for promoters but wreck the financial system of the United States it would be possible to do in months that which could never be done in traditional Washington fashion. With the information and the urgency that further financial catastrophe will demonstrate it might be possible to muster patriotic bipartisan support to put into effect financial legislation now for the next administration.By the way what are you thinking letting BlackRock, who hatched this mess act as guardian for US taxpayers of the $30billion Bear Stearns bail out fund?