Auction Rate Securities: Who's To Blame?

Includes: C, MER, UBS
by: Michael Steinberg

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 (NYSE:UBS), Merrill Lynch (MER) and Citigroup (NYSE: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