The Hidden Costs of The Auction Failures

Posted by John Carney, Feb 14, 2008, 3:44pm

Unless you are in private wealth management, the term “auction rate securities” might be new to you. But over in the private wealth group, they’ve been treating these things as if they were cash. Clients were funneled into the bonds and told they were the most liquid investment short of actual cash. But yesterday the bond auctions failed in a dramatic fashion, leaving many investors in illiquid positions.

All that you can read in the Wall Street Journal today. But what the Journal doesn’t explain is that this investor liquidity is already having repercussions in the broader marketplace, including the stock market. Many individual investors would use the proceeds from the auction of their bond holdings to purchase equities. Now that they are locked into the bonds, they are effectively frozen out of the stock market. Brokers have told DealBreaker that many clients simply will not be able to purchase stocks until the market for auction rate securities begins operating again, and they expect this lack of purchasers will have a depressive effect on stock prices.

The situation could deteriorate further. Investors who need liquidity might be forced to sell stock, or refrain from making major purchases—such as homes. So far most of the attention of market watchers has been focused on the direct effects of the auction failures. But if this doesn’t turn around soon, there could be major financial consequences.

Debt Crisis Hits a Dynasty [Wall Street Journal]

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Posted by Michael, Feb 14, 2008 3:51PM

remember that a lot of corporations use auction rates for their cash mgmt as well.

Posted by Captain Obvious, Feb 14, 2008 3:51PM

"...they expect this lack of purchasers will have a depressive effect on stock prices."

Can someone walk me through this one real quick? I got corn that needs diggin up.

Posted by I'm a dude, Feb 14, 2008 4:02PM

wouldnt exactly call $1b a dynasty. guy from Greenhill should have known better.

Posted by , Feb 14, 2008 4:06PM

@3:51 Like Bristol Myers, which fired their Treasurer and Assistant Treasurer last week, as a result of losses of a few hundred million from investments in auction rates.

Posted by Tipster, Feb 14, 2008 4:06PM

Check out Nuveen and BlackRock closed end funds performance over the past two days.

Posted by inIT4the$, Feb 14, 2008 4:09PM

Don't feel too bad for the holders of auction rates (depending on the language) they end up with the max rate as long as the auction fails, the cost of which is born by the issuer (sucks for them) of ARS (auction rt secs).

ex.

Harris County Health TX Mem 17800M 7D 11.000 MBIA


That's not even the max rate, but what I'm getting paid for 7 days tax-free (annualized of course). Anyway, yeah you can't get your money back, but your being paid a ridiculous interest rate). Yes there are many problems with this market at the moment.

Posted by Anal_yst, Feb 14, 2008 4:21PM

Calamos, Eaton Vance, Pimco, Cohen Steers, Neuberger Berman, Gabelli, ING, and Evergreen (and others obviously) all also had failed auctions today, this should be fun to watch it play out...wonder (as i did in opening bell) who'll be the 1st borrower to default

Posted by Anonymous, Feb 14, 2008 4:24PM

Just to show you how massive the credit mess is. Nothing Ben can do. He keeps lowering rates, nothing happens. Yield curve gets steeper, but that's a high price for everyone to pay.

When is the "banking" bailout going to be announced? They are lobbying for it right now. It's got to be anytime soon. Paulson is so easy to read.

Bitches!

Posted by Spitzer's Echo, Feb 14, 2008 4:27PM

@4:09 PM

Aren't those high rates ephemeral? Those underlying securities will be "called" and "refinanced" or I'm not getting this?

Posted by , Feb 14, 2008 4:29PM

who are the largest ARS issuers?

Posted by 1-2, Feb 14, 2008 4:34PM

I was on our bank's hoot yesterday (and garnered a little more information today), so here are some important notes:

1) This really is a shit-show. You could hear fear and confusion in everyone's voices.

2) These securities were sold as cash-equivilants, but (I swear to god) on the box they actually said to FAs "these should no longer be treated as cash/cash-equiv...they are now fixed income." This raises a few questions:
a) How many tort lawyers are crafting a class action suit against all the banks right now? 50? 100? This is going to be the next huge securities gold-mine for the legal begals.
b) Since these were expected to be extremely liquid, what happens to HNW clients who get PE capital calls and can't access their requisit cash? How will the PE firms handle multiple investor defaults?
c) What are firms who use ARCs/ARSs to manage intra-month cash supposed to do? These products haven't failed in years (if ever). If I am GE and use these products to manage cash *knowing* that they would roll-over every two weeks (say for payroll), how do i access the cash I need? Obviously you can borrow, but they're only giving you 50-80% release at an (expected) high interest rate. Instead of making money earning interest you are now paying for liquidity you don't have.

3) Apparently there are HFs out there who are buying this shit up like wild fire. They have excess cash and these products are going to be extremely high yielding so long as the markets won't clear, so they're taking their negative liquidity preference and being paid mightily by the banks to take these off their hands. Yet another example of how the "vultures" are actually keeping our system on track...for now.

4) Apparently the banks have been backstopping this market for 3 months now. 80-90% of these auctions would have failed without the underwriter taking on their unsold inventory, yet no one was made aware of this. Lesson: don't think that liquidity problems will go away if you just wait long enough--history shows they don't. As Keynes' said, "the market can remain irrational longer than you can remain solvent."

There are a plethora of other notes, but those are the main ones we've thrown around today. As an aside, even though i am being personally screwed (1/3 of my portfolio was in these for various reasons, none of which had to do with making an effort to enter the securities) I don't think anyone should be bailed out over this. Why? Because no one thought about the fact they were actually taking on risk; they should have. Heck, even i didn't read any of the print involving these--and I should have. There is a reason these had a higher yield than tresuries...they weren't risk-free...nothing is...and that's a lesson that must be re-learned.

Posted by , Feb 14, 2008 4:36PM

you know the banks can't provide liquidity again until the yield curve is steep enough they can earn their way out of the capital hole they have created so please explain why everyone is so opposed to lower short rates and a steeper curve? banks cannot recapitalize while the 2yr notes are below the funds rate.

Posted by Liquidity Man, Feb 14, 2008 4:37PM

There are some real bargains out there... and a lot of crap. The attractiveness depends on the liquidity of the underlying investments in the issuing vehicle. For example, PIF is a bad issuer since they hold illiquid (insured) muni bonds and have to sell them cheap to raise liquidity or face a horrible cost of funds on their auction prefered securities... MIN is a good issuer since the fund holds US Govt guaranteed paper (like treasuries, SBA's, etc.). Pick through them carefully and you can make a mint here.

Posted by miami, Feb 14, 2008 4:42PM

There's not going to be any class-action suits. Corp cash, and HNW cash gets invested only AFTER you fill out one of those forms detailing exactly what the broker can invest in.

If Muni ARS [which had Never failed in 20 years] was checked off, then the broker could put you in them, if not, they couldn't - THEN you can sue, but it won't be a class-action it will be a one-off.

Whatever the legal documents say is what will hold up in court. Relying on a market not to seize up once in 20 years....caveat emptor. It's not cash, so you shouldn't have thought it was cash. That's why the yield was higher.

D.U.H.

Posted by hedgingrisk, Feb 14, 2008 9:06PM

I knew things were bad inside the beltway, but this is plain stupid or said a different way, scary that we are at this point in the power curve. First the M3, and now this...

http://www.economicindicators.gov

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Posted by guest, Feb 14, 2008 10:38PM

So Why are all posts from 4:50 to 9:06 Suddenly DELETED. Is Ben Bernake suddenly editing the BLOG?

Seriously WTF?

Posted by guest, Feb 15, 2008 8:10AM

1-2 I often hear that quote attributed to Keynes but have never been able to find where it is he allegedly said it. Do you happen to know?

Posted by guest, Feb 18, 2008 10:02AM

Given the lack of support by banks to provide liquidity, what would cause investors to return the market....As someone pointed out, these securities should be consider fix income products. Investors "thought" these were liquid investments which is not the case...So why return to the market?????

Posted by diablo, Feb 18, 2008 10:42AM

guest @ 10:02 AM

I also see this market frozen, probably for good. Anyone sees how it would restart?

Posted by guest, Feb 18, 2008 1:12PM

the only way I see the market restarting is if there is some type of government intervention....maybe, as this market failure speads to other markets and the economy, policy makers may find it necessary to intervene in the situation...I wonder if Uncle Sam will take auction rates instead of cash come tax time...wealth taxpayers are sitting on auction rates so that they could pay their taxes....

Posted by shivelys, Mar 06, 2008 12:02AM

Can someone explain to me why UBS can legally freeze the investments that people have in auction rate securities? My parents are invested in them right now, and they can't withdraw from their investment. What do you think the likeliness of them being able to get their money back is? They actually did try to get their money out once they saw that UBS wasn't doing so well, and the financial rep talked them out of withdrawing, and told them their investment is safe. My mom wanted to transfer their full investment via wire to their bank account, but the rep told them they can't because she didn't have a form signed by my parents authorizing them to do transfers from their account, but then my mom found out that they did have a signed form, and when she told then rep that, the rep said, oh the form is expired now, because it's been over a year (but the form doesn't say that it expires after a year). Does anyone know if my parents could sue and win in this situation? Any advice would be really helpful. my email address is sshively5@yahoo.com

Posted by shivelys, Mar 06, 2008 12:05AM

In regards to the above posting (shivelys), I forgot to mention that my parents tried to withdraw from their investment BEFORE it became frozen (obviously). So they could have withdrawn, hadn't the financial investor told them false information.

Thanks for your advice!

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