Tuesday, April 01, 2008

UBS to lower valuation of auction-rate securities

There was a story on Reuters Saturday entitled "UBS to lower auction-rate securities' values" that says that UBS will lower the valuations for auction-rate securities on client account statments that "will range from a few percentage points to more than 20 percent." The story (based on a story in the Wall Street Journal) did not offer any clues about how they would derive valuations in an allegedly "frozen" market. Also, the market fails to make clear that "value" does not indicate liquidity. Unless and until there is a liquid market for auction-rate securities, any valuation is simply value on paper and does not indicate the true value or intrinsic value, let alone a price that that a client can get when attempting to sell the security.

I could speculate that the valuation might approximate the approximate price that the underlying long-term bonds would trade at if auction-rate securities funds were to be unraveled and the bonds distributed to investors in the funds. I think that might be a semi-reasonable way to "value" an auction-rate security in the short-term, but I say semi because that fails to take into account: 1) the higher rates of return that ARS holders get as a result of the penalties for failed auctions, and 2) the prospect that most ARS securities will be refunded as the bond issuers payoff the bonds after reissuing them as non-ARS debt in order to escape the onerous penalty rates. Still, your broker is obligated to provide a valuation that has some relation to what price you could get if there were a liquid market. Alas, any "value" based on a liquid market when there is no liquid market is an exercise in futility. About the only benefit of these reduced valuations is that it gives clients a "warm" feeling that their broker is finally recognizing to some extent the level of financial pain that the client is experiencing.

That said, unless you have a short-time liquidity problem, there is no need to lose ANY sleep if you are a holder of auction-rate securities. There are simply too many people (bond issuers, fund managers, brokers) with vested interests in eventually (within 12 months?) unwinding auction-rate securities for them to sit back and not unwind these securities as rapidly as they can. It may be painful to watch and wait, but those penalty rates will financially reward you for waiting. Also note that the unwinding process is based on the financial health of the debt issuer (e.g., municipalities, the Port Authority of New York, etc.) and not any Wall Street investment bank that might shaky right now.

At some point we may see the development of a truly liquid secondary or even tertiary market for trading ARS, but they may offer prices at a level analogous to a pawn broker and not be a wise choice for any ARS holders who do not have extremely urgent short-term lquidity problems in their lives. Sure, if you need the money today you have to take what you can get, but if you do not need the cash today or the next 12 months, it is okay to ride out the storm with the safe knowledge that you will receive the full value of your investment and then some (due to the high penalty rates.) The lower "value" proposed by UBS really relates to people seeking short-term liquidity, not the "value" for investors willing to wait for the ARS market to get unwound. Also note that UBS is just in the middle and the value and safety of the ARS is in no way dependent on UBS itself. Sure, UBS may have marketed ARS and made implied promises about them, but ARS are third-party funds managed by those third parties and not directly controlled by UBS.

You might also want to take a look at what the Financial Industry Regularatory Authority (FINRA) says in their recent press release entitled "FINRA Issues Guidance to Investors Caught in ARS Auction Failures." They have some comments on issues related to borrowing on margin against ARS. If you do wish to file a complaint related to ARS, one route is FINRA's Investor Complaint Center.

-- Jack Krupansky

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