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Hard Times for Auction Rate Securities

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By: Chris Kentouris | March 30, 2008

Merrill Lynch & Co., Morgan Stanley and Citigroup were sued by clients last week in separate actions; UBS and its brokerage arm were the target of litigation earlier this month. Those are the tip of the iceberg in a series of legal maneuverings and finger-pointing by disgruntled investors who purchased auction rate securities (ARSs).

In all the cases, investors claim that the firms misrepresented the risk of ARSs and that they should be compensated for losses incurred when auctions they promoted failed; some are even seeking punitive damages.

The brokerages counter that they informed investors that the securities do not have the same liquidity as money market funds and should not be held accountable for problems related to the broader liquidity crunch.

The turmoil in the $330 billion market has presented investors with a twofold problem: how to find ways to sell their holdings and how to value what they own to meet financial reporting requirements. The investors--typically corporations, hedge funds and high-net-worth individuals--can no longer value them at par, nor can they simply mark them down to zero.

Auction rate securities are a type of long-term paper backed mainly by municipal bonds, student loans and collateralized debt obligations. They are sold in increments of $25,000 and their interest rates are reset every seven to 49 days through an auction process controlled by some of Wall Street's largest broker-dealers.

Invented in the mid-1980s, the securities drew attention because they offered better short-term yields than equivalent investments. Investors often treated the securities as "cash-equivalents"; issuers, in turn, benefited from low borrowing rates.

There have long been warnings about ARS issues, particularly those backed by student loan payments. "It is our opinion that current holders should strongly consider redeeming existing holdings issued by Academic Management Services [AMS]," wrote Lance Pan, director of credit research for Newton, Mass.-based Capital Advisors Group, in a July 2003 report after the student loan organization faced collateral problems and disclosure issues. Pan went on to say that the selection of a good servicer was among the most important aspects of a given ARS note.

"While the initial market anxiety over the AMS incident may die down, we fear the student loan auction rate securities market may be headed into a danger zone that has not been fully appreciated by many participants," he cautioned.

Brokers Back Out

But investors now say that broker-dealers who promoted ARS deals assured them there was nothing to worry about--if there wasn't a sufficient number of bidders, they would step in to buy the securities themselves. While such agreements were never legally binding, they became widespread in the industry.

Almost five years after the AMS event, investors have either written off or will need to write off hundreds of millions of dollars worth of ARS because there aren't enough interested bidders. Investors have lost confidence in many types of debt instruments and many of the firms that once used their own funds to keep auctions from failing are no longer willing to do so given their exposure to other subprime-affected securities.

The list of sponsors of auctions that have failed over the past few months includes the biggest names on Wall Street: UBS, Merrill, Citi, Goldman Sachs, RBC Dain Rauscher, Lehman Brothers, JP Morgan Chase & Co. and Morgan Stanley.

"Most of the issuers are in good financial condition so it isn't a credit problem but a larger liquidity issue involved," said Ernie Patrikis, partner at law firm Pillsbury Winthrop Shaw Pittman in New York. "Investors flocked to safer securities so there weren't enough bids, and the investment banks were under no legal obligation to buy the securities."

In its recent 10K statement, Bristol-Myers Squibb said it took $392 million in impairment charges for its holdings in auction rate securities, representing a discount of 48.3 percent. 3M Worldwide said it wrote down $18 million in the value of ARSs--a 52.9 percent discount.

"Broker-dealers essentially gobbled up more of the paper than they could absorb and began to back out of their implicit commitments to investors," said Espen Robak, president of New York-based Pluris Valuation Advisors, who spoke at a Web seminar on March 25, hosted by the Finance Leadership Exchange, an Arlington, Va.-based network of CFOs and finance professionals.

Investors are stuck with securities they can't sell and issuers are often "penalized," which means they must raise the interest rate they will pay investors based on the terms of their offering documents unless they refinance their debt. The Port Authority of New York & New Jersey, for example, saw its interest rate on one of its auction rate issues soar to 20 percent from 4 percent after a failed auction in February.

Valuation Difficulties

With liquidity drying up, investors are left figuring out how much to write down their values. "Certain auction rate securities may now be worth less than par value," noted Robak. But not all ARSs have been affected equally.

The Financial Accounting Standards Board has not issued any specific guidance on auction rate securities but the new FAS 157 requires firms to come up with a fair value for securities they hold. That value depends on establishing an exit, or sale, price.

Without a public market for the securities, investors have to set "artificial" prices, which their auditors need to approve based on permitted methodologies. "Most fund managers know if they hold the securities to maturity they will collect par value but in the interim have to take into account new yields to maturity," explained Christopher Mears, audit principal in Roseland, N.J. with Rothstein Kass, an accounting firm specializing in hedge funds.

This fall Rothstein Kass will address the pricing methods used by clients, according to Mears, and will be tapping independent valuation providers and market makers for help.

Robak said that Pluris values ARSs based on prices for comparable positions traded in the secondary market or on projected future cash flows, discounted depending on an appropriate yield for illiquid securities of similar credit quality.

One such secondary market is being promoted by Pluris affiliate Restricted Stock Partners (RSP). Backed by minority investor Pequot Ventures, a unit of Pequot Capital, New York-based RSP has 150 ARS issues available for purchase on its online trading platform--Restricted Securities Trading Network (RSTN)--which until now has specialized in private placement securities.

RSP chief executive Barry Silbert calls RSTN the largest secondary market trading platform for corporate treasurers and other investors who want to find out what their securities could fetch. "We are trying to add transparency to the market, but the bids and offers are still pretty wide in many listings," said Silbert. "Holders are taking a wait-and-see approach while buyers are looking for heavy discounts."

"Between 10 percent and 30 percent of the market will never trade at par again," said Silbert. He declined to say what percentage of bids and offers on his platform result in executed deals.

Heavy Discounts

Industry experts say that discounts can range from 5 percent to 50 percent. Auction rate securities backed by student loans, which account for an estimated $80 billion of the market, appear to be among the most heavily discounted, those backed by municipal paper the least.

"Municipal paper is the most attractive type of auction rate security because there is a greater likelihood that the securities will be refinanced and the interest rates paid by the municipalities will be higher than those for other" ARSs, said Silbert.

He expects spreads to tighten as more buyers and sellers enter the market. Listing securities on RSP's trading network is free; the transaction cost--2 percent of the value of the securities--is split between the buyer and seller.

TheMuniCenter, a New York-based municipal bond trading platform owned by Citi, Morgan Stanley, Lehman Brothers, Merrill and Financial Security Assurance, plans to offer ARSs, according to John Craft, director of business development. "We are an important player in the e-trading of munis and this will be an adjunct to our business offering broker-dealers, hedge funds and retail investors price discovery and liquidity," said Craft.

While corporate portfolio managers praise efforts to provide liquidity, they caution that they are not a panacea. "As a selling investor you must be willing to take a significant hit," said Joe Morgan, head of portfolio management for San Francisco-based SVB Asset Management, which in 2004 began warning customers of the risks of ARSs.

Morgan recommends that clients call their broker the day before each auction date with an order to sell their holdings. That ensures, according to Morgan, that the broker is aware of the client's wishes and the client can receive par value if the auction is successful.

Over the long term, companies should search for investment advisers that are registered and understand their fiduciary responsibility. "Many corporations didn't understand caveat emptor when buying the auction rate securities from their broker-dealers," said Morgan. "The brokers did not follow the investment policies of their clients in spirit."

Pan of Capital Advisors also urges his corporate clients to think twice before trying to sell their securities in the secondary market. "Many issuers are working to provide some remedy to investors in refinancing their debt," he said.

Although brokers may not have bailed out customers at auction, Pan still encourages clients to seek their help, calling them the best source of liquidity. "The biggest problem with trading in the secondary market is that buyers are opportunistic and the sellers might do better holding onto their securities a while longer," he noted.

UBS, for one, has said that it is working with investors to offer margin loans and lines of credit at preferred lending rates.

Regulators are also trying to encourage liquidity. The Securities and Exchange Commission on March 14 said that it would allow municipal issuers of ARSs to buy back their securities if there weren't enough willing investors, provided that proper disclosures were made.