Figuring Out ARS Freeze

November 01, 2008 at 04:00 AM
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Since the auction rate securities (ARS) market froze in February of this year, the Securities and Exchange Commission (SEC) has gotten 11 of the largest financial services firms to buy back billions of dollars in (ARS) from their customers. Scads of other firms' ARS activity are under scrutiny now–as FINRA continues its sweep investigation–and Congress is promising regulatory reforms are on the way.

Indeed, Representative Barney Frank (D-Massachusetts), chairman of the House Financial Services Committee, said during his opening remarks at a September hearing he held on ARS, that "people who've been victimized [by auction rate securities] have been sophisticated and not. We need to have a regulatory system that provides safeguards." Thus, he said, Congress will be "adopting a set of regulatory reforms going forward" that address auction rate securities.

Just what happened in the ARS market, and why did it freeze? Over the past 25 years, the ARS market grew to a whopping $330 billion market because ARS offered higher rates of return than Treasuries or money market funds. ARS are municipal and corporate bonds, as well as preferred stocks, with interest rates or dividend yields that are periodically reset through auctions, usually every seven to 35 days. But, as Rep. Spencer Bachus (R-Alabama), ranking member of the House Financial Services Committee, noted during his opening speech at Congressman Franks's ARS hearing, "many of the firms that sold ARS did not disclose that with increased yield came additional risk. Indeed, many investors who purchased auction rate securities have asserted that they were marketed as the equivalent of highly liquid money market accounts."

Linda Chatman Thomsen, director of the SEC's Division of Enforcement, agreed during her testimony before the House Financial Services Committee that "broker/dealer firms that underwrote, marketed, and sold auction rate securities misled their customers." Through their sales forces, marketing materials, and account statements, she said, "firms misrepresented to their customers that ARS were safe, highly liquid investments that were equivalent to cash or money market funds. As a result, numerous customers invested in ARS their savings and other funds they needed to have available on a short-term basis. These firms failed to disclose the increasing risks associated with ARS, including their reduced ability to support the auctions."

Thomsen said that through the Division of Enforcement's settlements-in-principle with UBS, Citigroup, Wachovia, and Merrill Lynch, "over $40 billion in liquidity is expected to be made available to tens of thousands of customers in the near future."

The huge size of the ARS market was one factor that caused the market to freeze up, Thomsen said, because "the larger market required the firms to find more and more customers to bid in the auctions." Another contributing factor for the market seizure was the rating agencies' downgrades of monoline insurers like Ambac Financial Inc. and MBIA Inc., "which provided insurance for many ARS to ensure that holders would receive repayment of their principal if the issuer defaulted." The downgrades, she said, made customers unwilling to invest in ARS.

The subprime mortgage and credit crisis that unfolded in the second half of 2007 was also a contributor because it limited firms' ability to support auctions with their own capital, Thomsen explained. "Firms stopped supporting the auctions in mid-February 2008, and the entire market froze in a matter of days. The securities became illiquid, leaving tens of thousands of customers unable to sell their ARS holdings."

Arbitration and Enforcement Aplenty, Now

Susan Merrill, chief of enforcement at FINRA, told the House Financial Services Committee in her testimony, that to date, more than 225 arbitration cases involving auction rate securities have been filed in FINRA's Dispute Resolution forum. As a result of its sweep investigation, FINRA has 50 enforcement inquiries regarding ARS that are "active and ongoing," she said. The sweep is studying, she said, "auction rate marketing materials and advertising communicated by the firms to its customers; supervisory issues surrounding the purchases and sales of such securities; as well as possible conflicts of interest where a firm may have been in possession of knowledge about ARS failures and liquidated their proprietary ARS positions by selling those positions to [other] customers or ahead of customer liquidations."

As far as what's next for the ARS market–besides regulations being mulled by Congress and potentially more settlements afoot–Cliff Kirsch, a partner at the law firm Sutherland LLP in New York, says "It's a big question mark where [the ARS market is] headed." Clearly, he says, "This marketplace was one of the first indicators of the trouble to come."

William Galvin, chief securities regulator for the Commonwealth of Massachusetts, told the House Financial Services Committee in his testimony that any ARS reforms would have to deal with disclosing conflicts of interest as well as advisor compensation as some of the broker/dealers that have agreed to settlements provided "significant incentives for advisors to push ARS." Galvin also said that advisors need to be properly educated about selling ARS, and B/D reps must be held "to a fiduciary standard of care."

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