The freezing of the market for auction rate securities was a crisis last winter. Now many investors whose funds were locked up in auction rate securities are counting their blessings. Skyrocketing LIBOR has meant high returns for the auction rate securities. What’s more, with so much money stuck in auction rate securities, many investors have avoided losses in the worst stock market in recent memory.
While most investors stuck holding auction rate securities are still mightily pissed off and convinced they were swindled into a bad investment, they’ve out-performed the market recently. Indeed, some who cursed the brokers who sold them the securities are now a lot wealthier than they would have been if they had access to their funds.
High Yield “Cash Equivalents”
Back in February, the market for auction rates securities dramatically seized up. The securities had been marketed to investors as cash equivalents. The securities were bonds and preferred stock whose interest rates were set at auction every week or so. This gave investors assurance that the securities could be quickly sold off, and allowed issuers to borrow long term debt while paying cheaper short term rates. The yield was higher than money market funds, making them attractive alternatives to many investors.
What few investors or issuers understood was that the markets were extremely dependent on the market-making activities of the banks that underwrote the securities. When bids at the weekly auctions fell short of offers, the banks regularly stepped in and bought up the excess inventory. This kept interest rates low and the markets liquid. While things were good, banks were happy to do this because they collected fees both from issuers and from investors.
When The Dancing Had To Stop
A combination of events brought this happy arrangement of higher yield for investors, cheap money for issuers and ubiquitous fees for investment banks. First, accountants started to warn clients that they would no longer allow auction rate securities to be accounted for as cash equivalents. This lowered demand among corporate investors who were forced to move money our of auction rate securities to maintain their cash positions. It also alerted many sophisticated investors that the auction rate securities carried an illiquidity risk.
As demand plunged, the underwriters found themselves having to purchase more and more of the auction rate securities. In February, after the credit markets seized up and banks sought to bolster balance sheets by deleveraging, nearly every investment bank ceased supporting the auctions without any notice to investors or issuers. The markets simply froze up, with auctions failing across the board.
Some auction rate securities carried high “penalty” rates that kicked in if the auction rate securities failed. This meant issuers wound up paying extremely high interest rates while they scrambled for cash to redeem the securities. Hedge funds stepped in to buy the high-penalty rate securities, sometimes earning a hefty return as issuers struggled to refinance the debt amid a growing credit crunch. Investors in these types of auction rate securities benefited from high interest rates, a robust secondary market and issuers eager to redeem. Although there were some opportunity costs to having the securities turn temporarily illiquid, the high penalty rates probably more than made up for it.
Other auction rate securities, however, lacked this safety feature. These paid low interest rates linked to LIBOR even after the auctions failed. Issuers facing a tight credit market often chose not to redeem the securities, and hedge funds were not interested. Without redemptions or a secondary market, investors simply found themselves unable to access their funds. For many, it seemed they faced an indefinite future of low-yield securities that were sometimes 30-year bonds or perpetual preferred stock.
Brokerages Bailout Investors
Within retail brokerages such as Merrill Lynch, this quickly became an untenable position. Investors were angry at their brokers, many of which were as surprised by the auction failures as their customers. Some left or threatened to leave. What’s more, investors who needed cash were forced to pull money out of the financial markets. This put downward pressure on popular investments, creating cascading losses for brokerage clients.
Initial attempts to avoid client flight and unwinding equity positions were met with resistance by investors. The brokerages offered to lend money to clients, with the auction rate securities serving as collateral. Basically, clients would be able to use the value of their auction rate securities to make margin investments. But these margin accounts charged interest to investors, and put investors at risk of margin calls if the securities were deemed impaired.
Lawsuits against both issuers and underwriters were filed, both by investors and regulators. Federal and state regulators began investigations. Within a few months, most underwriters agreed to buy back some or all of the outstanding auction rate securities they had sold to clients. The buybacks, which cost brokerages billions, were scheduled to be unrolled under several months. Although investors balked at the delay, many were grateful to see a light at the end of the auction rate tunnel.
That delay, however, saved many investors millions of dollars. Investors who might have invested at least some of the money from auction rate securities in stocks found themselves locked out during a period when the S&P fell by 35%. One investor we talked to saw his stock portfolio fall by over 50% during the period. For these people, the failure of the auction rate securities markets turned out to be an unexpected blessing.
“It was an accidental wealth protection program,” one investor told us.
What’s more, the return on these securities grew as the financial markets became stressed. LIBOR’s rise meant that even the low penalty rate securities were paying as much as 6%, a far better return than was available in most other areas of the market.
It’s not clear what effect this might have on lawsuits over the auction rate securities. Investors will certainly have a harder time proving they were damaged by not having access to the market. What would they have bought with money frozen in the markets? Stocks, commodities, bonds and real estate have all suffered. It may be that a court could find that even if investors were defrauded, it could also conclude there were no damages.
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