Retail Investors stuck with 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.

Sphere: Related Content