Auction Rate Securities: Who's To Blame?

The Wall Street Journal's “UBS to Pay $19 Billion As Auction Mess Hits Wall Street” reports on state attorneys general entering into settlements with banks on auction rate securities [ARS]. UBS (UBS), Merrill Lynch (MER) and Citigroup (C) have agreed to buy back more than $36B,as well as pay fines. The process will start with individuals and charities in October and institutional clients in mid 2010. Over 100,000 individuals were included in the more than $330B sold.

The basis of the complaint is that investors were misled about the safety and liquidity of ARS. While the market was drying up, the banks temporarily stepped in to support the auctions. This gave the illusion of liquidity as the bank tried to unload their inventory through their retail channels. Commissions for the product were increased at many firms, and a Merrill Lynch analyst’s dire warning was enhanced to say only ARS offered “higher returns in exchange for less liquidity.” Apparently, even this subtle warning was buried so deep in Frances Constable’s report that no one found it. Merrill Lynch even categorized ARS as “other cash” on clients’ brokerage statements.

In "Auction Rate Bonds are not Cash Equivalents" and "Retail Investors stuck with Auction Rate Securities", I wrote about how investors should have known that they actually purchased long term bonds. And in "Mechanics of Auction Rate Securities", I explained the convoluted market for ARS almost guarantees liquidity crunches from time to time. So how were so many smart people lolled into complacency? I think the answers are greed and laziness.

Sure, the banks consciously tried to hide the liquidity risks, and the reduced monoline ratings accentuated the problems. But investors should have understood the maturity of the bonds they purchased, and the market for trading them. Retail investors, charities, and small and medium sized business are very lucky to be bailed out. It is difficult to know how large businesses will fare. Those being helped should keep in mind that the only reason they are being helped is the desecration the ARS caused public finance. The attorneys general had little sympathy for investors.

This scandal reminds me of the analysts’ scandal emanating from the dot-com crash. In both cases the investors knew they were being taken for a ride, but greed and laziness prevailed. The only sympathy I have for ARS investors is that the Alan Greenspan era made many desperate for yield. Many people pushed further out on the risk scale then they might have been comfortable with. The banks soothed their fears and they say took advantage of them.

Why did the banks lose and have to buyback the ARS, while they came off relatively unscathed in the dot-com bust? The difference here is that ARS trade in a captive market. When I bought municipal bond unit trusts in the 1980’s, I knew that was also a captive market. But no one told me it was just like cash. Captive markets present disclosure risks to their sponsors.

Disclosures: Author is long C and UBS

Comments

[john s. gordon:]

greed conquers all.
> jack

2008 Aug 10 08:24 AM

[Augustus:]

The real kicker in these deals was the provision for the lock in at very low rates in the event of a series of failed auctions. If the rates had been allowed to continue to increase, the borrowers would have had to payoff these bonds and get other financing. The lenders would not have suffered from the crunch.

2008 Aug 10 01:23 PM

[banval:]

Another kicker, is that one of the big German i-banks/broker-dealers put derivatives into the Auction Market at off-market levels. Orange County Redux! The securities were never worth par in the first place. These investors got toasted, and it was inevitably going to blow up. The subprime crisis was just the spark.

2008 Aug 10 05:11 PM

[MichaelNYC:]

Michael Steinberg - I don't know if you bought ARS for yourself or not, I'll assume you didn't. Happens to be I did. I have corporate and other accounts at Chase, and the sales person definitely marketed the AUS as cash, same as a Chase Money Market account except if you buy the 7 days lock up or the 4 week lock up, you’d need to manage you needs for those periods. No prospectus was given to me or anything else. In fact I had a substantial amount in a Chase MM account for years and this money went into AUS. It happens to be it was a 501 (c), and there's no question in my mind of what I was told. All of you who in previous comments on this article scream "buyer beware", should have been there and then you can talk.

If the Chase wants to be a bank it shouldn’t have sales people from Case Securities sit right next to my regular relationship manager and have that person have access to my Chase bank accounts to see how he can help me take money out of my case MM account and put it into AUS. I know of other Chase customers who were put into AUS as interchangeable vehicle for Chase MM or CD accounts. There was no disclosure, just the opposite. Sounds like somebody was making more money on the AUS, so that was being pushed.

I wonder why the others are forced to buy back the AUS and not Chase so far. As soon as the liquidity evaporated in AUS, the Chase thieves circled the wagons, it was almost comical, announced they couldn’t communicate about AUS by email only phone – it was pretty sad. As much as I don't like lawyers and AG Cuomo (or his father) I find that Chase’s behavior throughout the AUS saga was and still is very shabby and if it takes Cuomo to slap them around, unfortunately, so be it. I hope Chase is somehow not protected by the Fed for being the “good guys” on Bear. Nothing would surprise me anymore.

2008 Aug 10 06:29 PM

[DougM:]

I echo MichaelNYC's comments - this was my experience as well. As to how the product differed from short CDs, I understood that I was buying muni bonds and that the interest income was tax-free. The interest was actually lower than what I might have gotten on CDs, but it was higher after-tax given my tax bracket. I accepted that there might be a somewhat higher credit risk in the bonds in exchange for the tax-free return. I did not realize that there might be interest-rate risk associated with being stuck in the bonds - I was never given a prospectus and the products were never described to me as "auction-rate securities", they were described as "7-day paper". The instruments showed up on my statements as bonds, in the muni section - I did see the long maturity dates, and this troubled me somewhat. I was only given more details when I began to ask questions last October. I did this only because the insurance wrappers on the bonds appeared to be falling apart as MBIA and Ambac were teetering on the edge of AAA downgrades. This was the first time I was sent a brochure explaining how an auction-rate security worked. Unable to find out what the penalty rate was on my bonds, I sold them, and dodged a bullet.

2008 Aug 10 08:35 PM

[Hooboy:]

I just don't understand how you can be comfortable buying something without having a decent grasp of the what you were buying and what the mechanics were going to be.

2008 Aug 10 08:49 PM

[MichaelNYC:]

Michael Steinberg - I try not to trust anyone (at least theoretically I know that's the correct behavior) still when an employee of Chase is involved it's a bit different. I would not buy these if a street broker offered them to me. At one point I even said “so this is like Chase commercial paper" and he said “yes”. The amounts are well over the FDIC limits so by keeping the money in a Chase MM I had to believe that Chase's credit would be ok and I did. It was a large sum and 97% of the cash on hand in this 501(c) , if this wasn’t a true “money market” just like the Chase MM, shouldn’t a Chase (Securities) employee say something? By the way, the branch didn’t seem to mind that a large sum went out of their account and went into AUS. I assume they were getting earning credits for the AUS also. It’s funny how Chase wants to be seen as a bank, yet make money and shaft their clients like the big boys on Wall Street. It’s really annoying how they behaved on this matter and I wonder if they think the clients won’t remember this in the future and hold it against them. When the Chase folks tried to be “helpful” and offer loans against the AUS, I told them to shove it. I hope they fold soon for their own good because eventually they will, given the other players folding, and they are just hurting themselves by protracting this.

DougM – what that a bank, can you tell me please which institution it was?

hooboy – you know, life’s busy and here’s a Chase employee… I was told the credit was insured munis, as to the liquidity he assured me that it was fine. In hindsight of course I’d act differently. Still this does not excuse their nondisclosure and as I wrote above their intermingling of Chase Bank and Chase Securities.

2008 Aug 10 09:54 PM

[Serge Birbrair:]

Michael Steinberg, do you have proof that Attorney Generals have no sympathy for investors or is it hearsay? I don't want to be "lolled into complacency" and I am questioning your expertise on the subject.

How could investor know that investor was buying the long term bond when no prospectuses were offered and the only information investor could rely upon were:
words of their brokers
published materials by brokerage companies telling them that the investment was "Cash Alternative"?

I appreciate your Monday Quarterbacking, but I see no substance in your post whatsoever.

There is a poll going on if you are incompetent or just enjoy your pontifications, stay tuned, we'll know by the end of the day from investors.
nothingcontroversial.c...

Have a nice day and do me a favor, do some due diligence before you write your next "well informed" opinion.

P.S. when you get the proof about the alleged positions of AG's we, the investors, are in the constant contacts with - please feel free to post them here for all to see how right you were.

All - this will be a very long wait, bring your pop corn and folding chairs.

2008 Aug 11 07:47 AM

[Willi:]

I also purchased ARS's. I purchased them when I transferred money from a bank money market to AG Edwards. I asked my broker about money market rates and he suggested a SLAR because they pay a slightly higher interest rate. This set up no red flag because the rate was just a small amount higher than their money market. He also told me I would have "immediate illiquidity" which was true at the tine because if I sold, Edwards would immediately credit my account and carry the SLARs on their books until the next auction. This whole transaction was handled through emails, no written materials were supplied, and nothing was signed. Less paper work than opening a money market account.

After the auctions started failing and I asked for a prospectus, my local office didn't have one and it took two weeks for the main office to get me a copy. And a copy it was - 200 pages off a copy machine. Not even a normal prospectus.

Part of the blame for this needs to be placed on the SEC, IMO. In 2006 when they examined ARS auction fraud and fined a number of brokerages, they knew of the "auction" problems and the risks but still chose to allow the brokerages to sell these without providing any written disclaimers, prospectus etc. However, this doesn't excuse the fraud perpetrated by the brokerages in selling these as "money market equivalents", "totally liquid", etc. when they knew this wasn't true.

Edwards/Wachovia still hasn't announced any redemption and I'm still waiting for liquidity in my "totally liquid" SLARs.

Willi

2008 Aug 11 10:46 AM

[Mikaele:]

I asked all the questions you claim I was to lazy or greedy to ask and was told,
this is cash equiv and totally secure from a FA I have known for years.
What you wrote sounds like you have only heard about one side.
Your side! Please research more and write it over.

2008 Aug 11 01:28 PM

[Serge Birbrair:]

Michael Steinberg, Cuomo, who is indeed very sympathetic to the banks and not investors, per your story,
invites more bankers to settle with investors he has no sympathy for, according to your fairy tale.
For your reading pleasure:
www.bloomberg.com/apps...

I hope you don't have anything against real journalists who do their due diligence.

2008 Aug 11 01:39 PM

[arpholder:]

MIchael, you have no idea how these securities were sold. We gave our broker instructions to buy short term AAA rate municipal bonds and corporate paper. We were told that these were AAA rate corporate and municipal bond funds that were "redeemable" every 7 days like money market funds. However, you had only weekly liquidity. There was no mention of auctions. No prospectus. We bought frequently one year cds, short term treasuries, and AAA rate municipal bond funds redeemable "weekly". We correspond this in writing and by email frequently. Near the end--these securities had maybe a 50 basis point advantage over cds and treasuries. There was never a mention of a fixed rate ceiling. Everytime you buy a share of stock or a one year AAA rate municipal bond fund--you cannot read the entire prospectus. It is not practical. if everyone did that on these very simple transactions--the market would grind to a halt. It was very hard to even find the prospectus even after the collapse.

2008 Aug 11 08:54 PM

[Serge Birbrair:]

Like I said and 30 seconds ago Andrew Cuomo confirmed it:
His office represents the PEOPLE (us)

As far as penalty rates are concerned,
Michael, some of the current penalty rates are LOWER than they were prior to Feb 13th. Andrew Cuomo returns confidence into the market place and billions of dollars as well. When I get my money back, I'll buy real estate FOR CASH and us, the redeemed investors, will stop the slide of the housing market.

All well what ends well and I glad you taking this lesson in ARS in stride.

2008 Aug 14 11:45 AM

[MichaelNYC:]

Chase caved - I still think they are pieces of crap and I for one hope I don't forget and hold it against them.

2008 Aug 14 01:27 PM

[User 270145:]

Say NO to Pimco
Pimco is not qualified to handle the nation’s financial assets….they continue to hold their own customers prisoner in Auction Rate Preferred Securities – and have not been subjected to regulator scrutiny of these fraudulent instruments Pimco created, packaged and sold. If Pimco cannot deal honestly and openly with its existing customers on ARPS they cannot be entrusted with the national bailout.

2008 Sep 25 09:54 PM