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.