Tuesday, November 24, 2009

NASAA Enters into Historic $61 Billion Auction Rate Securities Series of Settlements with Financial Services Institutions

The North American Securities Administrators Association (NASAA) has reached settlements with more than a dozen financial services institutions regarding the inadequate disclosure of the auction rate securities (ARS) that were sold to public investors. The terms of the settlements require the financial services institutions to repurchase more than $61 billion in auction rate securities from investors. This is the largest return of funds to investors in history.

Numerous financial services institutions have entered into settlements with NASAA for failing to adequately disclose the risk of auction rate securities, misleading investors by falsely assuring them of the safety of ARS, and/or failing to supervise and train its sales agents. The financial services institutions that have entered into settlements with NASAA include: Wells Fargo Investments LLC, Wachovia Securities LLC, Merrill Lynch, UBS AG, TD Ameritrade, Inc., Bank of America Corp., Goldman Sachs Group Inc., Deutsche Bank AG, JP Morgan Chase & Co., Citigroup Inc., Morgan Stanley, Goldman Sachs, and Credit Suisse Group AG.

Auction Rate Securities (ARS) are long term, variable rate bonds tied to short term interest rates. ARS have a long term nominal maturity with interest rates that reset through a modified Dutch auction process, at predetermined short term intervals, usually 7, 28, or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest is paid at the current period based on the interest rate determined in the prior auction period. Although ARS are issued and rated as long term bonds (20 to 30 years), they are priced and traded as short term instruments because of the liquidity provided through the interest rate reset mechanism. Frequent issuers of ARS include traditional issuers of tax-exempt debt such as municipalities, non-profit hospitals, utilities, housing finance agencies, student loan finance authorities and universities.

The interest rate on ARS is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing investors who wish to sell or hold ARS only at a minimum yield. Existing investors and potential investors enter a competitive bidding process through broker-dealers. Investors specify the number of shares, in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept. Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the “clearing rate.” This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no ARS, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.

The Dutch rate mechanism makes ARS a form of derivative—that is, ARS derive their interest rate based on an underlying interest rate as determined by the Dutch auction process. There is often a derivative contracts intertwined with the ARS. The derivative contracts are supposed to reduce costs for the issuers by hedging their interest rate risks. Derivatives are not safe securities. I wrote an article on the riskiness of derivatives, and how average investors are often manipulated into investing in derivatives almost two years ago entitled Controlling a Financial Jurassic Park. Derivatives are one of the most sophisticated and riskiest investments amongst the array of financial products in which investors can invest. Yet the number of average investors that are manipulated into investing in derivatives is staggering. ARS investors are typically high net worth individuals (for tax-exempt issues) or corporations (for taxable issues). Not surprisingly, money market funds are ineligible to hold ARS due to Securities and Exchange Commission Rule 2a-7, which restrict money markets to securities with a final maturity of 397 days or less. This is a key indicator that ARS are not liquid securities that are easily convertible into cash.

Despite this data, financial service institutions involved in the NASAA series of settlements repeatedly told investors that auction rate securities were a “safe, liquid alternative to cash, certificates of deposit or money market funds.” Regulators alleged that ARS were marketed as safe, cash-like investments. In actuality, ARS are not cash-like investment as evidence by the freeze in the $330 billion auction-rate securities market last year. When the ARS market froze, in part due, to the lack of liquidity in the banking system, banks refused to allow investors to exchange their ARS for cash. Investors were dismayed at the financial institutions’ refusal to convert their ARS investment into cash, especially since their ARS had been marketed to them as nearly identical to cash.

The financial services institutions served as broker-dealers that operated the auction-rate market on behalf of municipalities, nonprofits, and closed-end mutual funds and were paid 0.25 percent of the security’s total issue for each year of its life. However, with the frozen ARS market, financial services institutions were and continue to earn servicing fees when 70 percent of the weekly auction rate securities are failing. Additionally, financial services institutions are earning banking fees when issuers redeem the securities, and financial services institutions make additional revenues when they assist issuers untangle from derivative contracts that are often intertwined with ARS.

All of the financial services institutions that have entered into settlements with NASAA have agreed to: (1) fully reimburse certain investors who sold these securities at a discount after the market failed, (2) consent to public arbitration to resolve other investor claims as a result of their inability to access their funds, and (3) pay millions in penalties to the various states whose residents were misled into purchasing the auction rate securities. NASAA President and Texas Securities Commissioner Denise Voigt Crawford stated that "we will continue to seek much needed relief for investors who have suffered from the collapse of the ARS markets."

Lydie Nadia Cabrera Pierre-Louis


  1. wonderful post professor.

    will the settlement redound to the benefit of the investors who have lost investment value based on the false information provided by the broker dealers?

  2. It never ends. The public always seems to lose even when they are buying "safe" investments. What's the point. The rich get rich off of the backs of the uninformed. It will never change. Government can't do anything about it.

  3. Thank you for your comments. They are appreciated. Unfortunately, the settlements will not restore "full value" to the investors that have lost investment value. The investors will receive the return of their initial investment on a pro rata basis less expenses including administrative and legal. Any uptick, that is, unrealized increased value from the initial investment is lost. However, investors should receive a sizeable portion of their initial investment. At least that is the plan.

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  8. anonymous, 12.8.11, 8:48 p.m.:

    personal attacks and excessively salty language are not acceptable in this format.

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