Is Andrew Cuomo going to force Wall Street to bailout institutional investors who bought auction rate securities? So far most of the offers to buy back auction rate securities that have come from brokers have applied to retail investors, charities and municipalities. The idea was that these investors were probably the focus of regulator protection and more sophisticated investors knew or should have known the risks in the market.
CNBC’s Charlie Gasparino is reporting that Cuomo’s dissatisfaction with the settlement offers from Merrill Lynch and Morgan Stanley stems, in part, from a concern for institutional investors. Pension funds and others own large amounts of the securities, and Cuomo may be pushing Wall Street firms to offer relief to these customers as well. This could seriously increase the cost of bailing out this market to the firms involved.

Across Wall Street, brokers are pressuring closed-end mutual funds to redeem their auction rate preferred securities, hoping to shift the cost of the market meltdown to the issuers before regulators and others forces those who sold the securities to make investors whole.
Yesterday we mentioned that Merrill brokers were upset that BlackRock, one of the largest issuers of ARPS, hadn’t redeemed a larger percentage. This is just one example of a dynamic playing out across Wall Street. Citigroup is reportedly considering buying out the ARPS it sold to investors, a move widely seen as an attempt to hold off regulatory scrutiny. Now other firms, especially those already laden with debt in frozen markets, are attempting to avoid incurring the costs of bailing out ARPS investors by drawing attention to the role of the issuers.

So how did Wall Street convince all those corporate treasurers to invest the cash holdings of their companies in disastrous auction rate securities? A new study shows that more than 85 percent thought that Wall Street firms would bail out the market if it failed, according to this morning’s Financial Times.
Nearly 70 per cent of corporate treasurers who bought auction-rate securities said dealer support was implied. A full 17 per cent of the treasurers said that they were “told explicitly that the investment bank would ensure that the auctions would not fail.”
For years, the firms selling auction rate securities did support the market by buying excess securities, guaranteeing the auctions would not fail. When scrambling to increase balance sheet capital earlier this year, nearly every firm on Wall Street that had sold the products decided to let the auctions fail. Since then issuers have been forced to bail out those securities paying the highest interest rates, while investors with those paying the lowest interest rates have simply been unable to access their funds.

Auction-rate securities ‘implied support’ [Financial Times]

Bank customers with funds locked up in auction rate securities are discovering that even if they find willing buyers for their securities, they may not be able to sell them. Earlier this year, nearly all the auctions for the securities failed as banks pulled their support for the auction. Customers, many of whom believed the securities were safely liquid cash-equivalents, found themselves unable to access their funds. While some issuers who faced high penalty rates following auction failures have redeemed their ARS, hundreds of millions of dollars remains locked-up.
It is an ugly situation that has bank customers bringing lawsuits against their brokers and the issuers of the securities. And it just got worse. According to Bloomberg’s Darrell Preston, Bank of America, UBS, Wachovia and at least four dozen other firms that sold ARS are blocking attempts to create a secondary market for the securities. They say they are preventing customers from selling at a discount and incurring needless losses.
Maybe the banks really do only have their customers’ best interests in mind. But the move also serves the interests of the banks. For one thing, preventing customer losses also makes it harder to sue the banks for their role in the ARS market.

“By allowing customers to sell at a discount, the banks allow customers to establish damages,” said Bryan Lantagne, the securities division director for Massachusetts Secretary of State William Galvin.

And the banks may have another reason to avoid allowing a secondary market. It’s still unclear about how much ARS are held directly by the banks themselves but some reports suggest they may hold a great deal. Since few of these default, the banks can carry these on their balance sheets at par value or close to it. But if they start trading at a discount in the secondary market, the banks will have to mark these at market value, incurring another round of write-downs. In short, the banks have an interest in preventing the formation of a transparent market in auction rate securities.

Banks Say Auction-Rate Investors Can’t Have Money [Bloomberg]

Despite the happy headline reading “Auction-Rate Securities: How to Get Unstuck: you probably can’t get unstuck. The secondary market for auction-rate securities has all but dried up as the issuers facing the highest interest rates have refinanced. By the time you get to the end of this Business Week story you’ll find the sad tale of John Tierney, who was told by Smith Barney that he couldn’t sell his auction-rate securities.
In other news, investors in auction rate securities have filed a suit against Goldman Sachs. The lawyers representing the investors say “Goldman Sachs misrepresented the securities as cash alternatives, which turned out to b”e liquid solely because of artificial manipulation of the auction market.

Auction-Rate Securities: How to Get Unstuck [Business Week]

When the Culinary Institute of America needed to raise money to pay for a new building they turned to a Goldman Sachs banker for advice. He told them to issue auction rate securities. That piece of advice cost them nearly half a million dollars when the market seized up and the interest rate of the securities shot up to 14 percent, Bloomberg reports.

Auction-Rate Collapse Costs Taxpayers $1.65 Billion [Bloomberg]

Why did the market for auction-rate securities collapse so violently earlier this year? Shortly after the auctions seized up we published a “primer” on what had happened, explaining that changes in the way corporations account for the securities. With corporate demand gone, banks found themselves having to soak up more and more inventory. The capital commitment required to do this grew at the same time the banks faced challenges from other parts of the credit markets, and eventually the banks decided to let the auctions fail.
This view is echoed in a new article in Compliance Week, a weekly newsletter on corporate compliance and risk management. Most of the article is devoted to a discussion about how financial officers should value auction-rate securities. (Short answer: It’s complicated!) But there is also a good discussion why the auctions failed. And by “good” we mean: “totally agrees with us.”

Espen Robak, president of Pluris Valuation Advisers, says the jitters over credit markets aren’t entirely to blame for the ARS freeze. Guidance from the Securities and Exchange Commission and from Big 4 audit firms told investors they couldn’t view ARS as equivalent to cash, so they became less popular as a cash management vehicle for corporate treasuries, he says. That contributed to the sell-off and dwindling number of buyers.
Robak says companies went on a selling spree in the latter half of 2007, shedding some $70 billion in ARS: “That’s an awful lot of paper to change hands in such a short period of time.”

Cos. Face Auction Rate Insecurities [Compliance Week]