Auction rate securities: the crash you didn't hear about
In this morning's Tennessean, there was a teeny little two column-inch piece (so tiny they didn't put it on their website, so I can't link to it) about securities regulators from several states raiding Wachovia's headquarters in St. Louis over "the collapse of the $330 billion auction rate securities market."
"Hmm," I thought. "That sounds really interesting. I wonder what an auction rate security is."
It turns out that the story is much bigger, it's just that with all the chatter about subprime mortgages, collateralized debt obligations, inflation etc., this particular market collapse didn't make a very big dot on the radar screen.
Massachusetts led the group of 10 state securities agents in getting tough on those accused of misleading cities, student loan companies, and other debt issuers into the market for these long-term bonds that were supposed to have low interest rates that reset every week, two weeks, or month based on auction results.
The problem is, lots of these auctions failed, meaning they didn't bring high enough bids to cover minimum 3% interest rates, and when that happened, the interest rates reset to 20%. Yowch. The New England Patriots were one such issuer who were hit with the 20% penalty rate, and they sued the insurer over the auction rate debt the Pats issued in 2006 to raise money for their new stadium.
It started in March of 2007, when the Financial Accounting Standards Board (FASB) stopped letting auction rate securities be classified as "cash equivalent," which suddenly caused the corporations who used to buy them at auction have much less impressive balance sheets.
So investors stopped buying them. The market dried up like spit on a hot sidewalk in July. To add insult to injury, the investment banks overseeing the auctions stopped letting ARS investors withdraw their money, because the banks had to maintain a certain ratio of capital to assets, and they couldn't do that and let all the ARS investors have their money. So both the issuers and the investors in the transactions got screwed.
Wachovia is in trouble because of claims that investors were told they were buying securities "equivalent to cash or money-market funds," which they totally weren't after March of 2007.
Good old UBS, already in trouble six ways to Sunday, is also accused of misleading investors in auction rate securities. In a continuation of their recent string of mea culpas, UBS will repurchase up to $3.5 billion of auction rate preferred stock from clients who had it in their portfolios as of July 15, meaning those people will eventually get their money back.
But as this story unfolds and gains traction, I bet you'll find that a lot of other investors won't be so lucky.
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