Sunday, April 13, 2008

More of the backstory for auction-rate securities

If you are scratching your head and wondering why the problem with auction-rate securities (ARS) ever happened, you have to realize that we still do not have the complete story of the tortured path that led to the ultimate "freeze." An article in the New York Times by Gretchen Morgenson entitled "It's a Long, Cold, Cashless Siege" adds a few more clues, one of the most telling of which is that institutional investors had been bailing out of ARS throughout 2007, even as brokers were actively encouraging individual investors to put new money into ARS:

... even though Wall Street heavyweights and major corporations have been stung, many of them also appear to have bailed out of the market well ahead of individuals. At the end of 2006, institutional investors held about 80 percent of all auction-rate securities issues, according to Treasury Strategies, a consulting firm in Chicago. At the end of last year that portion had fallen to just 30 percent.

"A number of corporations understood there was a rising threat to their securities; there had been failures and warnings," Anthony Carfang, chief executive of Treasury Strategies, said in a conference call late last month.


As of July 1, 2007, corporations owned $170 billion of these securities, or just over half of the total outstanding, according to Treasury Strategies.

But through the second half of 2007, corporate investors were dumping their stakes, Treasury Strategies said. During these months, corporations cut their holdings to $98 billion.

At the same time, many individual investors were being persuaded by their brokers to buy auction-rate securities for the first time. Jacob H. Zamansky, a lawyer in New York, says he has 50 cases involving individuals stuck in auction-rate securities who say they weren't told of the risks. Of those, he said, 80 percent were put into the securities in the second half of 2007.


As big holders of these securities accelerated their selling late last year, Wall Street firms overseeing the auctions would have come under greater pressure to find buyers to make the auctions succeed. It is unclear whether they turned to individual clients to fill this void.

Lewis D. Lowenfels, a securities lawyer at Tolins & Lowenfels in New York, represents several investors who are stranded in auction-rate securities. "If the evidence shows that large corporate clients were being advised to unload these securities at the same time that the investing public was being counseled to purchase the same securities," he said, "one begins to slip over the line from questions of due diligence and suitability into the realm of securities fraud."

The article reports that Wall Street firms have a disincentive to fix the problem since they collect fees even if the actions fail:

Wall Street firms continue to earn the same fees for running the auctions -- typically 0.25 percent of the amount of shares or notes outstanding on an annual basis -- even though few auctions are succeeding.


How Wall Street is paid for these auctions is central to understanding why the firms have little interest in resolving the problem of failed auctions. The firms earn money at least twice: First, when the notes or shares are underwritten, they receive 1.5 percent of the amount of money raised, in the form of a fee. Then they receive 0.25 percent annually for conducting the auctions -- a total of $825 million this year, based on the size of the market.

But they receive these auction fees even when the auctions fail, so the firms have no incentive to help revive this market.

I would disagree with the assertion that they have "no incentive" since the tsunami of pending lawsuits and the risk of losing clients and client assets are clearly incentives.

On the bright side, the article does note that:

A UBS spokesman said that to help clients in need of liquidity, the firm had just begun a program to let them borrow 100 percent of the par value of their securities at a modest interest rate.

That is much better than a traditional margin loan, especially when UBS is now valuing ARS on monthly statements at some discount to par. This is not a long-term solution, but does help people who are stuck with very short-term liquidity problems.

It seems to me that there are a number of potential solutions, but the biggest impediment is that so many of these firms and the firms they depend on are struggling with even bigger problems. I suspect that as the credit mess settles down a little that we will finally see real movement on ARS. Whether that will happen in a month or three or six or twelve remains a key uncertainty.

In my view, if there is one key lesson here it is simply to dump your "full-service" broker and get a decent discount broker. I have more than $25,000 in cash (money market funds) at Fidelity and nobody was haranguing me to "invest" in a "cash-equivalent." A second lesson: DO NOT CHASE YIELD! NEVER! EVER! That is not a new lesson, but something that is literally as old as the hills. How people managed to forget it is a mystery. Some perverse combination of greed, stupidity, arrogance, and laziness. I have been doing the bulk of my investing through discount brokers for over nine years. Why so many people continue to see value in full-service brokers is a mystery to me. Opening and managing an account at Fidelity is truly easy. I suspect that it is simply because brokers are actually great salesmen and do a great job of convincing their "clients" that they are being "sharp investors" by trusting their broker and all of the "research" that the broker's firm provides. If this whole ARS episode proves one thing it is that people, even smart people with lots of money, are seriously gullible and susceptible to wily sales tactics that stroke their egos.

-- Jack Krupansky


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