Did Auction Rate Securities Ever Have A Natural Success Rate?

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When Wall Street withdrew its support for auction-rate securities, many investors discovered their cash is trapped. Their brokers told them their investments in instruments that were marketed as cash-equivalents were suddenly illiquid. Issuers who depended on the securities for financing are being told by their banks that they must refinance, and of course hand over deal fees to the very institutions that allowed the markets to collapse. And now many want to know why the auctions were in such dire condition that the banks decided the cost of supporting them was not longer acceptable.
“How long did they know the auctions were on life support?” one investor with nearly half-a-million dollars in now illiquid auction-rate securities asked DealBreaker.

The immediate cause of the auction failures was the pullback of the banks and brokerages. In mid-February the financial institutions conducting the auctions stopped acting as principals or buyers of excess ARS inventory. Investors and issuers were caught off guard, surprised by the sudden change that occurred nearly simultaneously and without warning. Even some within the financial institutions were caught off guard, with brokers learning only after the fact that their auction desks were allowing the auctions to fail.
“Wall Street executives have defended their conduct, saying losses on holdings such as mortgage assets have curtailed their ability to use their balance sheets to support faltering markets,” the Wall Street Journal’s Randall Smith and Liz Rappaport report in their article today about a large bond marketer lashing out against Wall Street over the auction failures.
But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.
“The truth is there was no natural auction success rate. But for the banks acting as market makers, these auctions would have failed from the get go,” a bond trader told DealBreaker.
Rather than merely acting as buyers of the last resort, the financial institutions have been consistently called upon to stabilize the ARS market. In many cases, investors were lead to believe the market was much healthier than it has ever been. But with balance sheet capital at a premium due to recent losses, the banks decided that the fees received for structuring the auctions and managing clients money in ARS were did not justify deploying the capital necessary to support the market.
If these bond traders are correct about the way the ARS market operated, Wall Street may soon find itself the subject of yet another round of lawsuits and investigations by authorities.

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