Tuesday, August 26, 2008

Auction Rate Securities: Who is to Blame?

New York Attorney General Andrew Cuomo continues on the crusade of his predecessor, former Governor Eliot Spitzer, even though the prosecution of Wall Street investment banks threatens the vibrancy of the New York economy and complicates attempts to restore liquidity to the mortgage and credit markets. The newest focus of Mr. Cuomo’s litigation is the investment banks that were involved in the auction rate securities (ARS) market. Auction rate securities are generally long term debt instruments with variable interest rates that reset periodically. On daily, weekly, or monthly reset dates, an auction is held where investors can bid to purchase securities or offer their holdings for sale. Supply and demand establish a market clearing interest rate enabling ARS to trade at par. As the grasp of the credit crunch slowly choked the life out of the investment banks, they abruptly withdrew their liquidity bid that had maintained order in auctions that are often characterized by low volume and order imbalances. Without an independent liquidity provider ensuring balance between buy and sell orders, dramatic seizures in the auction rate securities market ensued, entrapping investors in illiquid securities that often have provisions capping interest rates in the event of auction failures.

Auction rate securities, on their face, are a valuable financial innovation that has enabled borrowers to secure long term financing for lower short term rates. They have funded municipalities and infrastructure projects for decades, providing investors with compelling yields on money market instruments. In order to boost underwriting fees, the investment banks issued ARS as financing for closed end mutual funds and other investment pools. These securities contain complicated formulas that limit changes in the interest rate when an auction fails, effectively disrupting the market clearing mechanism that enables these securities to trade at par. The investment banks were forced to provide liquidity bids and acquire significant quantities of these ARS in order to ensure that the auctions for these poorly structured securities did not fail. Culpability was established once Mr. Cuomo uncovered a concerted effort by the banks to sell these securities to unsuspecting clients prior to withdrawing their liquidity bid, ultimately eliminating investors’ ability to liquidate securities that were advertised as cash equivalents.

The creativity of the U.S. financial system leads to market innovations that enable our economy to thrive, but also permits moral hazard to threaten the stability of our markets. Unfortunately, the investment banks have once again demonstrated a dearth of morals and fiduciary responsibility in their quest for personal riches. Their actions have undermined products that have increased capital market efficiency and provided financing to municipalities for decades. By marketing securities containing provisions that virtually guaranteed illiquidity to na├»ve clients, the investment banks caused widespread failures across the auction rate securities market and subjected many issuers to millions in additional interest expense. Akin to their reckless securitization of risky tranches of collateralized mortgage obligations (CMOs) and other toxic debt into collateralized debt obligations (CDOs), the investment banks have jeopardized the viability of broad asset classes that formerly provided essential liquidity to the U.S. economy. Unlike the mortgage and CDO markets, it was the interest rate caps and convoluted reset formulas that eroded liquidity in the ARS market rather than the quality of the underlying assets. Regardless, the investment banks’ pervasive abrogation of their fiduciary responsibilities and unrestrained pursuit of underwriting fees and trading profits has caused immeasurable damage to the U.S. economy and threatened the financial future of countless Americans.