Auction Rate Securities-Another Example of the Investor Losing

By Gus Krafve

September 5th, 2008

As if the current stock market correction and credit crisis weren’t enough, there is another slice of the financial markets that has caused angst among some investors. The market I’m referring to is the Auction Rate Securities (ARS) market. Many of you reading this piece probably aren’t familiar with the ARS market due to the fact that Trust Company of the Ozarks chose not to put our client’s assets in those securities. However, numerous banks and brokerage houses nationwide sold auction rate securities to many of their best clients. In fact, over 100,000 individuals and institutions invested over $330 billion in the ARS market. The ARS market’s roots date back to the mid-1980’s and the first tax-exempt issue was underwritten by Goldman Sachs in 1988.

So, what is an Auction Rate Security? Simply put, it is a bond. What differentiates Auction Rate Securities is: 1) the rate paid to the owner of the bond typically resets every 7, 28, or 35 days, depending on the issuer; 2) the final maturity of the ARS is usually much longer than most bonds, generally around 30 years; and 3) when the market is liquid, the underlying value of the ARS remains static and doesn’t fluctuate with changes in interest rates.

In theory, the ARS market was a win-win situation. The institutions issuing the bonds were able to borrow money long-term but only pay short-term interest rates which are usually lower; and the buyers of Auction Rate Securities were able to earn higher rates of return on their cash than they were getting in money market funds. Cracks in the ARS market began appearing last year when some of the auctions began failing due to a lack of buyers from the higher risk issuers in these markets. In early February, hundreds of auctions for these securities began to fail as buyers backed away, and the investment banks underwriting the securities failed to provide liquidity for the auction as they had in the past. By the end of February, the market for these securities was basically nonexistent.

In many cases, investors who were sold Auction Rate Securities were never told there was the possibility that they could get stuck with the bonds if the auctions failed. In numerous documented cases, it has been revealed that brokers selling the securities had told investors that if an auction failed, their firm would provide liquidity to the investors and bail out the auction.

The good news is that relief is coming. U.S. and state regulators have taken action against some of the largest brokerage houses, and in many cases, they have been fined and sued. Some brokerage houses have recently agreed to “do the right thing” and buy back the Auction Rate Securities at face value. However, as of the time of this writing, there are still over $200 billion of illiquid Auction Rate Securities in the hands of investors.

Trust Company of the Ozarks is a fiduciary and is required by law to act in its clients’ best interests. The fiduciary duty is the highest standard under which investment professionals can operate. Unfortunately, the majority of investment providers aren’t required by law and don’t choose to operate under the standard of a fiduciary.