Their work has proved especially valuable in providing an appropriate level of support for the annual independent audit of the Fund.

George J. McVey, Jr.
Dynamis Advisors, LLC & IMVA, LLC

Credit Crunch - Auction-Rate Securities: From Bad to Worse


By: Vidya Ram | April 17, 2008

Late on Thursday, nine U.S. state regulators announced they were setting up a task force to investigate the market for auction-rate securities (ARS), a $330 billion asset class that imploded during the credit meltdown, after being inundated with complaints from investors since February. Had banks acted improperly when they sold these assets on to their clients, marketing them to their clients as safe, high-yielding, cash-on-demand securities, without disclosing the risks?

As demand for the bonds, resold at regular auctions, seized up, banks wrote down assets not only on the securities on their own books, but those of their clients as well. Last month UBS (nyse: UBS), which has written down $800 billion of its own $11 billion portfolio, also announced they were reducing the value of the securities in the accounts of their customers by "an average" of 5%. The bank had previously assured clients that the assets were safe.

"Investors are telling state securities regulators that they did not know that their money was being held in auction-rate securities and were not advised about the liquidity risks," said Bryan Lantagne, director of the Massachusetts Securities Division and chairman of the task force. He said complainants ranged from "young families saving for a first home" to small business owners. "Their lives have been detrimentally impacted because the money they thought was liquid is now tied up in this frozen market."

Demand for auction-rate securities, the long-term bonds issued by governments and corporations, which have their interest rates reset at period auctions, soared over the past two decades, fueled by issuers who wanted to secure long-term financing at a low floating rate and buyers who were able to ignore the fundamental illiquidity of the assets because of the regular auctions.

Though auctions began failing as early as last August, they came to the forefront after brokering banks such as UBS, which had previously bought the securities when auctions failed, refused to take any more on their books and began marking down the assets belonging to their customers.

With nearly $100 billion ARS on its balance sheet, corporate America is feeling the collapse of the asset class too. In late January, Bristol Myers wrote down $392 million of its $811 million ARS portfolio, largely due to toxic collateralized-debt-obligation-backed securities, and most recently handset maker Palm wrote down $25 million on a $35 million portfolio. Companies from Continental Airlines (nyse: CAL) to eBay (nasdaq: EBAY) have disclosed ARS exposure running into the hundreds of millions but are yet to declare any write-downs.

In March, independent trading networks stepped in to the rescue when around 70% of the bond auctions began to fail, counting on demand from hedge funds and distressed asset seekers.

A month later, even the more sought-after ARS paying high penalty rates are selling at substantial discounts to their par value.

Municipal bonds are trading at discounts of 5% to 25%, while the auction-rate preferred stocks issued by close-end mutual funds are going at between 10% and 20% below par, Barry Silbert, chief executive of Restricted Stock Partners, which began listing auction-rate securities in early March.

The auctions for these assets have been failing by around 50% and 60% respectively, forcing issuers to pay penalty rates of up to 20%. For student-loan backed securities, where 100% of the auctions have reportedly failed, bidders are offering discounts of 30% or more, according to Silbert. In many cases, sellers are clinging on to their assets, in the hope of a revival.

There is little chance that the secondary market can cover anything near the entire asset class."We are getting hundreds of bids, but there is not $330 billion of capital looking to be put to work right now," says Silbert. Restricted Stock Partners, the largest secondary market for ARS, trade around 160 issues, worth around $500 million on any given day.

This is bad news for banks and corporations needing to revalue the ARS on their balance sheet.

When auctions fail, prices in the secondary market are almost the only way of gauging value, says Espen Robak, president of Pluris Valuation Advisors." Some of these assets are worth substantially less than what they were, but this is not being reflected in current valuations. I would assume further write-downs."