When a littleknown corner of the financial world hit a wall in February, auction-rate securities became an investor's worst nightmare.
Auction-rate securities are long-term corporate or municipal bonds with interest rates that reset at periodic auctions. For years, the market for auction-rate securi ties operated smoothly. From 1984 through 2006, only 13 auction failures were recorded.
Then, in February 2008, in the midst of a credit crunch, demand for auction-rate securities dried up, causing auctions to fail. Wall Street investment banks, which initially created the securities, in addition to conducting the auctions for them, compounded the problem by pulling their support from the auction market altogether.
When the market subsequently collapsed, investors holding auction securities were left with illiquid investments they could not cash out. It was like converting a liquid money-market fund to a 30-year bond.
Issuers of auction bonds-municipalities, charities, hospitals, universities and others-faced penalties in the form of higher interest rates, often in the double digits. With no foreseeable buyers for the securities, many issuers began replacing their auction-rate bonds with lower cost and less volatile debt.
As it turns out, that can be expensive. The state of New York is a prime example. New York is the biggest state issuer of auction-rate debt, with $4 billion. To date, that state has spent $138 million to rid itself of auction-rate bonds by converting to other forms of financing.
The unexpected costs for the conversion have come at the expense of other statefunded projects, such as providing preschool classes to children. In the end, New York's refinancing plan could total more than $340 million.
Making matters even worse: In most cases, the billions of dollars in refinancing fees that issuers must pay to convert their auction-rate bonds are paid to the very same Wall Street institutions that caused problems in the first place when they stopped supporting the auction-rate market six months ago.
At the heart of the auction-rate problem is the shattered bond of trust between brokers and clients. Many investors purchased auction-rate securities because they had been told by their broker that the instruments were safe, high-yielding cash-like investments. As it turns out, that wasn't the case.
State and federal securities regulators launched numerous investigations into the auction-rate issue following the market's collapse, filing civil charges and pledging to hold firms that misled clients accountable.
In August, Citigroup became the first bank to settle claims with state regulators by agreeing to buy back the auction-rate securities it sold to retail investors. Seven other Wall Street heavy hitters, including UBS, Merrill Lynch, Wachovia, JP Morgan Chase, Morgan Stanley, Goldman Sachs and Deutsche Bank ultimately followed suit, agreeing to buy back more than $50 billion worth of the securities and pay fines of $520 million.
The agreements, however, do not apply to $160 billion worth of auction-rate securities bought through mutual funds or brokers that didn't underwrite the debt. Nor do the settlements help corporate auction-rate securities holders.
This unknown aspect leaves institutional and corporate investors with few options. They can take legal action, attempt to make deals with their broker, sell their investments or hold on to the securities and see if liquidity is restored to the auction market.
During an Aug. 14 press conference on the recent auction-rate settlements, New York Attorney General Andrew Cuomo claimed the omission of a resolution for institutional investors was based on the fact that the retail segment of the auctionrate market-individual investors-had fewer resources at their disposal and were therefore his first priority.
While that may be the case, it's also true that many institutional investors-just like individual investors-bought auction rate securities because Wall Street banks repre sented them as safe, cash-like alternatives.
With payrolls to make, retirement plans to fund and businesses to operate, waiting several years for a resolution may not be a viable option for a number of institutional investors with auction rate securities.
Instead, their future remains in limbo because the promises made by Wall Street turned out to be as empty as their nowilliquid investments.
Hargett is a partner with the securities law firm, Maddox Hargett & Caruso P.C., with offices in Indianapolis, New York, and Cleveland. Views expressed here are the writer's.