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Wall Street Betrayal Seen in $4.8 Billion Company Debt Losses

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By: Dunstan McNichol | August 27, 2009

Aug. 28 (Bloomberg) -- Eighteen months after investment banks quit supporting auction-rate securities that were once marketed as an equivalent to cash, companies from Dallas-based Texas Instruments Inc. to Israel’s Teva Pharmaceutical Industries Ltd. have more than doubled writedowns on the debt to $4.8 billion.

While U.S. state and federal regulators have announced settlements with 23 banks since December 2008, obliging them to repurchase a total of $61 billion in the bonds from individual investors, almost all new sales are failures. More than 400 companies stuck with $22 billion worth of the debt are selling at losses of as much as 40 cents on the dollar to get cash, according to SecondMarket Inc., a New York-based brokerage firm. Others have decided to wait decades until the securities mature.

“We’re not happy about this,” said James B. Flaws, chief financial officer of Corning Inc. The glass-fiber maker is one of two owners of Midland, Michigan-based Dow Corning Corp., a manufacturer of silicone products that holds $1.1 billion of the securities in a market once worth $330 billion.

Corning wrote down its share of the portfolio by $33 million and reclassified the assets as a long-term investment, according to a Securities and Exchange Commission filing for the quarter ended June 30. Its affiliate trusted the auction-rate market after functioning smoothly for more than two decades, Flaws said in a telephone interview.

‘Very Liquid Market’

“They invested in auction-rate securities based on the understanding that this was a lot like a money-market instrument, and there was a very liquid market for these,” he said. “There should be a market for this. We are appealing, pressuring, trying to get the banks to reopen the market.”

While markets from mortgage to municipal debt have rebounded this year from the worst credit crisis since the Great Depression, with a record $875 billion in corporate bonds sold through Aug. 19, $160 billion of auction-rate securities haven’t been refinanced, according to Kevin O’Connor, a SecondMarket managing director.

Of 449 publicly traded companies holding $22 billion in the debt, all but 45 have recognized a loss in their value, according to a survey of SEC filings by Pluris Valuation Advisors, a New York-based firm that analyzes illiquid assets and is affiliated with SecondMarket.

‘Pain Was Great’

“The pain was great,” said Anthony J. Carfang, partner at Treasury Strategies Inc., a Chicago firm that advises companies on working-capital management strategies. “These guys have had sleepless months, and you don’t soon forget that.”

Bristol-Myers Squibb Co., the New York-based pharmaceutical company, took an 82 percent loss in 2008 when it sold a portion of its auction-rate debt with a $642 million face value.

The maker of Plavix, the world’s second best-selling medicine behind Pfizer Inc.’s Lipitor, continues to hold $169 million worth of auction-rate bonds. It wrote them down by $75 million in the second quarter, according to regulatory filings.

Rebecca Goldsmith, a Bristol-Myers spokeswoman, declined to discuss the actions.

The market’s collapse also caused “staggering losses” to Teva, according to a lawsuit filed Aug. 6 against Bank of America’s New York-based Merrill Lynch & Co. unit, which sold $273 million of obligations to the Petah Tikva, Israel-based drugmaker.

‘Elaborate Scheme’

The securities are now worth $10 million, according to the suit, which said that “Merrill Lynch was engaged in an elaborate scheme to deceive investors about its involvement in the auction-rate market.”

Ayala Miller, a spokeswoman for Teva, did not immediately respond to questions e-mailed to the company. Bill Halldin, a Merrill Lynch spokesman, declined to comment.

In April, Texas Instruments, the second-largest U.S. semiconductor maker, sued New York-based Citigroup Inc., Morgan Stanley and BNY Capital Markets Inc., now part of Bank of New York Mellon Corp., over $521 million in auction-rate securities bought since 2005.

“They let us believe they would be liquid,” the Dallas- based company’s treasurer, Charlie Tobin, said in a telephone interview. “At the same time, within their institutions, they knew it was coming to an end.”

During the first quarter of 2008 Texas Instruments reclassified its $533 million portfolio as a long-term asset and reported losses of $41 million as of June 30, according to regulatory filings.

Security Question

The chipmaker specifically asked Citigroup and Bank of New York whether the investments were secure after a series of sales failed in the summer of 2007, the company said in the lawsuit.

“Both Citi and BNY assured Texas Instruments that the Student Loan Auction Rate Securities would not fail at auction,” the company said in the suit.

In a June 8 court filing, Ellen Sessions, Carrie L. Huff and Michael L. Dinnin, attorneys for Morgan Stanley, Citigroup Global Markets and BNY Capital Markets, respectively, said Texas Instruments cannot allege any false or misleading statements and that the company hasn’t incurred any losses from the auction- rate portfolio.

“Plaintiff was a sophisticated purchaser of auction-rate securities and other investments,” the lawyers said in their filing. “It knew and understood the nature and risks of those investments,”

Danielle Romero-Apsilos of Citigroup, Christine Pollak at Morgan Stanley and Kevin Heine of Bank of New York Mellon each declined to comment.

Short and Long

For 25 years, auction-rate securities were popular with borrowers such as municipal governments, student-loan financing agencies and nonprofit organizations, which used them as a way to get short-term borrowing rates on long-term obligations. Some of the debt does not mature until 2047.

Banks oversaw periodic bond auctions, generally conducted every 7, 28 or 35 days and supported the sales by purchasing unsold debt. They stopped buying in February 2008 as credit tightened. Auctions have failed regularly since.

In July, only 408 of 3,035 auctions drew enough bids to allow bondholders to sell, meaning 87 percent failed, according to the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access Web site.

There is little prospect the traditional auction-rate market will ever return, according to Espen Robak, Pluris’s president.

‘Dead Asset Class’

“This is a dead asset class,” said Robak, whose firm estimated corporate writedowns on the debt reached $4.8 billion in the second quarter, against $2.1 billion a year earlier.

The 23 banks involved in the sale of the debt have negotiated settlements with state and federal regulators, paying $575 million in penalties and agreeing to buy back more than $61 billion of securities.

Merrill Lynch announced a settlement in principle with the SEC in August 2008 obliging it to buy back $7 billion in auction-rate securities by the end of this year. The agreement is not yet final, said agency spokesman John Heine.

Regulators are now focused on brokerages that sold auction- rate securities on behalf of originating investment banks.

Boston-based Fidelity Investments, the world’s largest mutual fund company, and TD Ameritrade Holding Corp. of Omaha, Nebraska, the third-largest retail broker by client assets, have agreed to repurchase a total of $956 million in auction-rate securities from customers.

‘No Involvement’

Charles Schwab Corp. of San Francisco, the biggest independent broker by client assets, was sued in August by New York Attorney General Andrew Cuomo, who said the firm misled customers about the safety of auction-rate securities.

“We did not create the products, actively market them, and had no involvement in the events that led to the collapse of the Auction Rate Securities market,” Charles Schwab, the broker’s chairman, wrote in an opinion article for the Wall Street Journal Aug. 19.

Most of the agreements initially required buybacks only from investors with less than $10 million in holdings, according to settlement documents. By early next year, the banks must make their best efforts to buy back securities from investors with larger positions.

Companies owning auction-rate debt often follow a 2007 Financial Accounting Standards Board ruling requiring holders of instruments for which there is no observable market to estimate a fair value. The price can be based on a formula the companies devise themselves and must be explained to investors.

Richfield, Minnesota-based Best Buy Co. reported a $14 million loss on its $312 million in auction-rate holdings during the three months ended May 30, according to filings.

Full Recovery

The world’s largest electronics retailer classified the impairment as “temporary,” because “we intend to hold our ARS until we can recover the full principal amount,” it said in a filing.

Sue Busch, a spokeswoman for Best Buy, declined to comment.

Of the $298 million in auction-rate debt held by the company, $274 million are in student-loan bonds backed by the U.S., regulatory filings show. The balance is in municipal securities.

UBS AG has promised to repurchase $89 million of the debt at face value by July 2, 2012, according to the retailer.

Zurich-based UBS, unlike most banks reaching regulatory settlements, agreed to buy back auction-rate securities at face value from any purchaser regardless of the portfolio size, said Mark Arena, a spokesman in New York.

No Need

UBS held $16.34 billion in auction-rate securities as of June 30, and was scheduled to buy another $8.47 billion back from customers by July 2, 2012, according to an Aug. 2 filing.

Not every company writing down the debt needs to draw on the assets immediately.

US Airways Group Inc., the country’s sixth-largest carrier by traffic, wrote down its $214 million auction-rate portfolio by $34 million, according to a June 30 filing. The Tempe, Arizona-based company has $1.7 billion in unrestricted cash and needs only half of that currently, Doug Parker, its chief executive officer, said in a call with analysts July 23.

Some auction-rate purchasers needing ready cash have sold the debt through specialty brokers such as SecondMarket for 60 cents to 80 cents on the dollar, according to the firm.

Of 29 companies that sold auction-rate holdings during the second quarter of this year, 15 had a market value of $100 million or less, said Robak.

Cable TV retailer ShopNBC, a unit of Eden Prairie, Minnesota-based ValueVision Media Inc. whose slogan is “Be Good to Yourself,” needed funds last month to load up on jewelry and beauty supplies for the Christmas selling season.

With $26.8 million in frozen auction-rate securities on its books, the company took a $7.4 million loss to free the stranded assets and received about 72 percent of face value for the debt, according to a July 10 filing.

The retailer, whose Web site offers 10 karat gold-and- diamond bracelets for $81.08, couldn’t afford to wait for the market to recover or the securities to mature, spokesman Anthony Giombetti said. “We wanted to get them off our books.”