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The Auction-Rate Security Mess: Read the Writing on the Wall

Aug. 10, 2008 6:57 AM ETUBS, MER, C14 Comments
David Enke profile picture
David Enke

The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus.

Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS (UBS), Merrill Lynch (MER), and Citigroup (C) alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided.

To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that it

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David Enke profile picture
David Enke, Ph.D., is an Associate Professor of Finance at The University of Tulsa, with research and teaching interests in the areas of financial risk management, quantitative and computational finance, financial engineering, enterprise risk management, investment and trading, and intelligent systems. His research involves forecasting equity, option, and commodity prices, modeling volatility, and managing credit, market, and operational risk. Additional activities include hedge fund replication, optimizing option-based spreading strategies, and assisting student investment funds. Much of his quantitative research involves the use of intelligent mathematical and computer models, including neural networks, fuzzy logic, evolutionary systems, agent-based systems, artificial life, data mining, and simulation. In addition to university and industry research in price forecasting and trading system development, Dr. Enke has numerous peer-reviewed journal articles and conference proceedings, book chapters, and edited research volumes. He is also an active investor, and comments regularly on his research interests at his blog, Bull Bear Trader (http://www.bullbeartrader.com/).

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Comments (14)

"Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to..."

Clearly, given the October crash, this comment is prescient. The failure of the ARS market was a warning shot, but no one knew what it was warning about.
The auction rate "mess" is another obstacle to those arguing for a bottom in the equity markets.
Though entirely after the fact - How is it that the entire planet knew that real estate in the United States was in a bubble? What contributes to a bubble, or perhaps even more importantly, how a government tasked with "oversight" could have NOT seen that risk was pandered like the ol' hot potato and contributing to the bubble's size? So, for those seeking actual investment contributions, where is the next "bubble"? IT'S THE VALUE OF THE U.S. DOLLAR! -- off my soapbox.
Opps .... caught robbing a bank...
SEC would say... Oh you have to give the money back...
but we won't ask you to admit guilt or any thing like that.

And for UBS, etc... no letting you get your money out....
What about DAMAGES.... I and many others, lost alot of time, sleep
and worry over this. After being lied to so badly by UBS, how could we be assured that We would ever see any of our money.

Punitive damages should be awarded.
Brokerage Houses.. Officers should go to JAIL.
1. Risk -- UBS knew of the state of risk in ARS... institutional investors went from 80% to 30% in 2007. Meltdowns in Jan 2008 were evident and still UBS recommended them as a buy.

2. Cash Alternatives -- UBS "Financial Advisors" (brokers) all sold these as as good as CD or Money Markets funds. UBS broke FINRA rules in that they were misrepresented as Auctions.

3. The higher rates were neigligible!!! They were only a .1 or .2 points... Investors did NOT buy them because of higher rates for acepting more risk.... Their higher yield was minimal. They were told by UBS that their was NO risk... They were cash alternatives.
Investors were told they could get their money out at any time !!!
No if ands and buts...

The world is now learning that BROKERS can NOT be trusted.
and Governments have been ineffective in regulating them and keeping them honest. A serious blow has been dealt to the Stock and Financial market. The implications for financing the US dept has yet to be fully played out.
This is the first time I've seen an assertion about Dark Pools affecting ARS, or for that matter any market. I expect that we will see more and more stories about how the perfection of Romulan cloaking technology for institutional investors has wreaked subtle havoc with just about everything.

But congratulations on being first.
5% interest? what kind of risk does that illustrate, around what a cd was paying. Quote {As we often forget, higher reward is almost always accompanied by higher risk - I dare say } if the reward was 8% then the lights are on for due dillagence 8% would probably equate. when multi billion dollar companys want to run a scam on you, its like a car accident, it just happens, its easy to write this article after the fact , go back to bed, David Enke
Merrill has promised to buy 12 billion worth. How much is that promise really worth, r123? Show me the money, and I'll start believing something Merrill Lynch says.
john s. gordon profile picture
suggest a federal 'lemon law' for financial products ?
> jack
10 Aug. 2008
"...how much money investors get back from auction-rate securities depends on who originally issued the securities..."
"...securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years."

But Barron's premise is not true now! How much money investors get back depends on who their brokerage is. An individual investor holding a CDO or student-loan ARS will get all of their money back in about a year if their account is with Citi, Merrill or UBS (may the list grow longer soon). Why are you and a few other columnists implying otherwise?
woodsey profile picture
Whatever happened to prohibitions against USURY?
Hint: Congress 1980.

what part of "Not FDIC Insured -- May Lose Value" do you guys not understand?
"As reported, UBS (UBS), Merrill Lynch (MER), and Citigroup (C) alone have committed to buying back more than $36 billion of the securities."

Where do the Citi, Merill and UBS get the money to buy back the securities ? Why would the issuer ( say the municipalities) redeem the securities because the brokers misled the investors ?
adan profile picture
re: "...The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk." -

definitely agree with this, but, honest transparent presentation precedes and allows this due diligence and understanding (of risk)

transpose the sale of almost anything else, a car, a toaster, a computer, and there'd be no question of who was primarily at fault....
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