A bedrock principle of the securities industry is trust – particularly between an investor and his or her broker. The auction rate security debacle, which is just one facet of the historic economic crisis that began with the subprime meltdown and may lead to an equally historic federal bailout, has severely eroded that trust. Little attention, however, has been devoted to the impact this has had on the customer-broker relationship.
To understand the problem, one must first understand the basics of auction rate securities. Typically known as ARS, auction rate securities are bonds with variable interest rates set at auctions every 7, 28, or 35 days. Sometimes known as auction rate preferred shares or municipal auction rates, ARS were generally regarded by investment professionals to be safe, liquid investments – the perfect place to hold cash on a short term basis. From the 1980s through 2007, the ARS market grew to $330 billion. Catastrophically, in February 2008, the ARS market suddenly collapsed, leaving hundreds of thousands of investors’ assets frozen.
For municipalities and businesses issuing bonds, ARS were preferable to conventional bonds because ARS allowed issuers to obtain long term financing at short term interest rates. Although ARS were essentially long term bonds, the short intervals between auctions mimicked short term investments; consequently, the issuers paid short term (low) interest rates.
Each ARS was sold at an auction where security holders offered their shares for sale and buyers bid to purchase them. In a normal auction, buyers outnumbered sellers and all “sell” orders were filled. Whenever sellers outnumbered buyers, however, the auction “failed” and no holder was allowed to sell that ARS until the next auction. As long as the auction continued to fail, no one could sell. The ARS retained their value, but they simply could not be sold.
To prevent auction failure and maintain the liquidity of the ARS market, the brokerage overseeing an auction would step in as a buyer of last resort. Investors took comfort in the fact that brokerages were ensuring ARS liquidity – although they were not obligated to do so – by preventing auction failure. But brokerages assumed this role more frequently than desired. For example, in the two years prior to February’s historic string of auction failures, one brokerage intervened to prevent the failure of more than 85% of its auctions.
As a result of the subprime crisis that gained momentum in 2007, brokerages were under pressure with their own credit and liquidity problems. Thus, they were unwilling to continue pouring money into ARS just to maintain the liquidity of that market. When brokerages finally could take no more and withheld their support in February 2008, many auctions failed, the entire ARS market quickly collapsed, and ARS investors (including brokerages themselves) were stuck with illiquid long term bonds.
Auction failures trigger complex penalty rate systems. Some ARS issuers, typically municipalities, were forced to pay high penalty rates to their bond holders. Many of these issuers decided to redeem the securities and those ARS holders got their money back. Most municipal ARS that were not redeemed recovered their liquidity when buyers were lured back by high penalty rates, allowing their auctions to resume. Other ARS issuers, such as student loan companies, faced penalty rates much lower than the rates set at auction. These issuers had no incentive to redeem their ARS, and investors faced the unwelcome prospect of holding billions of dollars of investments they could not sell.
As a result, investors filed dozens of lawsuits against their brokers and brokerages for failing to properly disclose the risks associated with ARS and their opaque auction process. At the same time, state and federal securities regulators began investigations and enforcement actions against several large brokerages. For brokerages with substantial portions of their own inventories frozen in the ARS market, taking on additional illiquid assets seemed an impossible solution. However, due to the immense legal pressure, by the end of August 2008, several of the largest Wall Street brokerages had agreed to repurchase more than $50 billion of ARS from their customers. In an effort to assure skittish shareholders and creditors, many firms announced that the regulatory settlements would not impact their bottom lines – leaving many investors to wonder why the problem arose in the first place.
Even if the ARS market were to fully recover or every brokerage eventually bought its customers’ ARS, the damage has been done. The lack of transparency in the auction process and the apparent industry-wide misunderstanding of the actual risk to investors were brought to light only when liquidity concerns led brokerages to stop supporting auctions. Whether through vigilance or chance, some investors managed to avoid the ARS debacle. Most investors, however, rightfully relied on securities professionals for expert guidance and were trapped with unmarketable investments. The ARS debacle has highlighted the fragility of the broker-customer relationship, and a culture of candor must prevail from brokerage to broker to customer if the industry is to avoid similar problems in the future.