The state of Hawaii took a $250 million write-down on the auction rate securities in its investment portfolio at the end of 2009, according to a recent Bloomberg report. The write-down included 57 issues of student loan-backed securities that were purchased from Citigroup for over $1 billion in 2007 and early 2008, when they were sold to the state as tax equivalents that could be liquidated within 7 to 10 days. But the state?like thousands of other investors holding auction rate securities?has been unable to liquidate, prompting the state to write down their value to $752 million. The liquidity problem with these securities has exacerbated budget woes for a state that has a $1.2 billion deficit due to the drop of tourism revenue tied to the recession.
Auction rate securities are variable rate instruments in which the rates are determined through periodic auctions, but since the auction markets collapsed in February 2008 the investors holding such securities have been unable to liquidate their investments. Problems with these securities were increasingly evident in the summer and fall of 2007 when auctions began to fail and rating agencies started downgrading the securities, but most broker-dealers failed to inform their customers of the increased risks and continued to misrepresent the product as a safe cash equivalent. Since the collapse of the market, many broker-dealers have entered into settlements with state, federal and industry regulators to redeem auction rate securities at par value. But not all investors are eligible for the regulatory settlements, and several broker-dealers have not agreed to settle.
Citi was one of several investment banks and brokerage firms to have entered into settlements with the SEC and various state regulators, but such settlements have primarily benefited individual retail investors. The SEC settlement required Citi to purchase illiquid securities from retail investors at par value, and established a claims procedure for those investors to make additional claims for consequential damages above and beyond their lost investment. Unfortunately for institutional and corporate investors, the SEC settlement only required Citi to use its best efforts to restore liquidity to their securities. Two years after the auctions froze, many investors are still waiting to liquidate, and a large number have filed lawsuits to force liquidation or recover damages. Others have been able to sell their securities on a limited secondary market, usually at a steep discount.
According to SecondMarket, Inc., a New York brokerage that specializes in finding buyers for illiquid securities like auction rate securities, regulatory settlements have restored about $94 billion to investors, but businesses continue to hold about $25 billion in securities that they have been unable to liquidate. Those numbers may be low, however, considering that investors of all stripes were holding a total of $330 billion worth of auction rate securities when the markets froze in February, 2008. While many of those securities have since been redeemed, there are still many individual investors who have not yet been able to liquidate?either because the firms they bought them from were not involved in regulatory settlements, which have primarily targeted the biggest market players in the states where regulators are most active, or because their holdings were above the monetary limits that would qualify them as retail investors under the settlements.
“Clearly the regulatory settlements have put a big dent in the problem,” says Craig T. Jones of Page Perry who represents investors in securities arbitrations and lawsuits. “But there are still a lot of people and institutions with a lot of money tied up in these things, and I am getting calls from potential new clients every day.”
Jones points out that liquidity is the biggest problem, but it is not the only problem with auction rate securities. When the auctions failed, many securities that were paying 4 to 5% interest were reset to a fail rate of less than 1% due to provisions in the offering documents that tied the rate to LIBOR or some other benchmark in the event that auctions were not successful. “To an investor with tens or hundreds of millions of dollars tied up in long-term bonds, that rate spread adds up to a lot of money.”
Jones’ law firm, Page Perry, is based in Atlanta but handles securities fraud and broker malpractice cases all over the country. “The thing people have to worry about now is that the statute of limitations, which is different in every state, will eventually prevent you from taking legal action to get your money back,” says Jones. “Depending on where you are and what type of claim you have, there may be special rules that extend the statute of limitation where facts have been fraudulently concealed from you, but you cannot afford to take any chances. If you are still waiting for your money at this point, you need to discuss your options with a lawyer now, before it is too late.”