The credit crisis triggered by the collapse of the subprime mortgage market has claimed its latest victim: auction-rate securities. These complex debt instruments are long-term corporate or municipal bonds or preferred stock on which the interest rates are reset periodically, typically every seven, 28 or 35 days. Assuming there are buyers, holders of these instruments can sell them on the reset days. The problem is that lately buyers have been few and far between. The $330 billion auction-rate securities market is experiencing turmoil and uncertainty it has never seen before.
Auction-rate securities have been popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other non-profit entities because financing costs are low, no third-party bank support is required and there are usually fewer parties involved in the financing process.
Until recently, auction-bond failures were a relatively rare occurrence. Unfortunately, this is no longer the case. As Martin Braun reported in a February 13, 2008 article on Bloomberg.com, during the past few weeks investor demand for the securities has declined precipitously as a result of increasing skepticism regarding the credit strength of insurers backing the underlying debt obligations, and the reluctance of banks like UBS, Citigroup and Goldman Sachs to submit bids and risk holding too many bonds. Indeed, nearly half of the $20 billion in securities put up for auction on February 12 failed to generate sufficient interest among bidders and none were sold. Merrill Lynch recently announced that it is reducing purchases of auction-rate securities that fail to attract enough bids from investors. UBS has decided that it simply will not buy such securities at all. Investors’ concerns about the credit ratings of the bond insurers backing the securities essentially caused the failure of these auctions.
When an auction fails, issuers are forced to abandon their offerings or pay exorbitant interest rates. The Port Authority of New York and New Jersey was recently forced to take the latter painful step. Although the interest rate on $100 million of bonds it sold during the week of February 4 was only 4.3%, the rate more than quadrupled, soaring to 20% on February 12. Wisconsin faced a similar dilemma at its 28-day auction of taxable bonds on February 12. Bonds that the state sold at 4.75% on February 7 jumped to 10% just five days later. Shortly after Ambac Financial Group, the insurer of student loan debt issued by Vermont’s Student Assistance Corp., lost its AAA credit rating, the interest rate was reset from 5% to 18%. Braun also reported that recent auctions for bonds issued by Presbyterian Healthcare in Albuquerque, Georgetown University, Nevada Power and New York State’s Metropolitan Transportation Authority and Dormitory Authority simply failed. According to New York Times reporters Julie Creswell and Vikas Bajaj, nearly 1,000 auctions failed during the three-day period between February 12 and February 14.
Bond auction failures can have devastating consequences for the issuers, whose only alternative is simply to pay the higher interest rates or cut back on their programs. Non-profit entities that depend on these instruments to raise funds for their institutions and programs — and municipalities that are forced to raise taxes to meet higher costs of borrowing — have been especially hit hard by the turmoil. In the wake of reduced tax revenues from a weakened housing market and looming recession, many state and local governments are worried about how they will pay their bills yet still provide essential services. As reported by Michael Quint in Bloomberg.com on February 15, the Municipal Securities Rulemaking Board — the top regulator for the U.S. bond market — is so concerned by the chaos in the auction-rate bond market that it plans to seek comment on whether dealers in these securities should reveal the number of bidders and disclose how often these auctions fail. The SEC, which in 2006 reached a $13 million settlement with 15 investment banks involved with bidding irregularities, is also considering whether to require increased disclosure about the auction process.
Investors in these securities have also been hurt. Many investors — individuals and institutions alike — who purchased the bonds believing that they were safe, low-risk securities equivalent to cash, now find themselves holding an investment for which there is no market. Several investors have already taken legal action against the brokers who sold the securities. Merrill Lynch, for example, is a defendant in a Texas action in which Metro PCS alleges that the firm misrepresented the risks involved and the suitability of the securities under the company’s guidelines. Lehman Brothers is the respondent in a FINRA arbitration complaint filed by two wealthy New Jersey brothers, alleging that the firm’s investment of $286 million in auction rate securities was inconsistent with the claimants’ stated investment objectives. Additional investor suits against other firms are likely to follow.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in counseling municipalities and other institutional investors regarding their subprime investment problems and have brought claims for investors with losses relating to subprimes. For further information, please contact us.