Monthly Archives: May 2008

As the landscape begins to clear for some holders of auction rate securities, for those holding $85 billion of such securities backed by student loans, the future is not so bright.

Student loan-backed auction rate bonds, sold as safe, liquid, cash equivalents, have been one of the worst performing segments of the market.  The problem is that the issuers of these student loan ARS have little or no ability to raise additional funds to redeem them.  Adding fuel to the fire is that the interest rates being paid on these ARS have fallen to zero.  The result, many investors are left holding positions that are illiquid and paying no interest.

Considering most of these investments were sold to investors seeking short-term growth with little risk and liquidity, the current prospects for the future are unacceptable. 

According to Aaron Pressman’s May 28, 2008 piece from BusinessWeek Online, while many municipalities have redeemed or are planning on redeeming the bonds they have issued, only one student loan issuer has announced a rescue plan.  The secondary markets are also failing to offer a solution for holders of these securities.

It is being reported that investors are likely to be stuck with as much as $70 billion worth of student loan-backed securities.  According to JP Morgan analyst Alex Roever, “current investors are at risk of having to hold positions until maturity, which in a few cases may be 40 years away.”            

The Securities and Exchange Commission plans to change the way credit rating agencies evaluate the risk of complex financial instruments. Recently, rating companies have been accused of embellishing the appropriate ratings for mortgage-related securities, especially after the decline in the housing market. 

Triple-A is currently the highest rating, meaning there is little chance the bond will fail, and if it does, little money will be lost. The new highest rating would be defined as Triple-A, S or V, representing structured or volatility.  The goal of the new rating scale is to insure inexperienced investors understand the risk of the structured product.              

But will a new rating scale be as effective as supporters hope? Many groups remain skeptical. According to Kara Scannell and Aaron Lucchetti in their Wall Street Journal article, SEC Pushes for New Risk Scorecard, critics believe the scale is not the problem, but the quality of ratings. Other lobbyists find the idea “counterproductive and will serve to further undermine, rather than restore, liquidity”.              

Credit-rating companies are taking the crisis into their own hands and developing new procedures. According to Standard & Poor’s Rating Services, the firm plans to improve on their current system instead of adapting a completely new scale. The SEC plans to vote on the entire proposal, which includes other changes as well, on June 11.  The proposal will then be sent to the public for comment before final approval.

Individual investors are not the only ones experiencing pains due to the frozen auction rate securities markets.  First quarter earnings show that more than 400 companies held at least $30 billion in these investment products.

Since February, the $330 billion auction rate market has largely been frozen.  Failed auctions continue even now, some four months later.  Large companies are struggling with how to price their holdings.  About half of the companies have written down the value of these securities.  The average markdown was 13.2%.

Companies are now looking for ways to handle their lack of liquidity.  Some are turning to secondary markets like Restricted Securities Trading Networks.  RSTN has arranged 200 auction rate sales with discounts ranging from 2% – 30%.

 About 25% of the $330 billion auction rate securities market has been bought back by municipalities or refinanced with new debt.  The remaining are likely not worth their face value. 

After 18-years, Citigroup veteran Reaz Islam, is leaving the firm.  Mr. Islam most recently was the manager of two Citigroup, Inc. hedge funds that have imploded over the last several months.

The hedge funds, Falcon Strategies and ASTA/MAT, are fixed income funds marketed to individual investors.  The funds were sold as low risk, conservative investments.  Over the last couple of months, both of these funds have been wiped out. 

Falcon Stategies has lost over 75% of its value and ASTA/MAT was at one time down 77%. 

Last month Citigroup set aside $250 million to help some investors recoup a portion of their losses.  Unfortunately, this set aside does not even begin to fully compensate for investors’ losses.  As a result, a number of lawsuits have been filed by aggrevied investors.  

Our firm is interested in meeting with investors of these funds in order to evaluate their investments to see if a case of action exists.      

The auction-rate securities market has now been frozen for over three months and it is not just the thousands of investors now holding these illiquid investments that are livid.  Many of the financial advisors who sold these products also feel duped.

The latest issue of Registered Rep. magazine highlights the anger of financial professionals.  These advisors are stepping forward claiming that they were told by their employers that these auction-rate securities were safe, money market-like investments.  Advisors were assured that the $330 billion auction-rate securities market was too big (and too important as a source of liquidity for investors) to fail.  We now know otherwise.

Many advisors interviewed in the piece noted that their firms’ never discussed risks of these products.  In fact, one former Merrill Lynch broker said that Merrill specifically trained advisors that auction-rate products were in fact cash equivalents.  Other brokers were told the same thing by the Wall Street firms.

So as the number of lawsuits and arbitrations increase, advisors are taking action to protect themselves.  Many are compiling information that they were provided by their firms to highlight Wall Street’s position as to these products.  But were the advisors really without knowledge of the risks?  There were warning signs after all.

In early 2005, all the major accounting firms were advising corporate clients to classify auction-rate securities as “investments” and not “cash equivalents” as they had done previously.  In addition, the SEC settled a case against 15 Wall Street brokerage firms in 2006 for violations relating to the attempts to save various auctions from failure.  These events were known, or should have been known, to the firms as well as the advisors.

Investors are mad and they should be.  They were sold a product carrying known risks as a safe, conservative risk-free investment.  Wall Street should not be let off the hook simply because historically the products performed without showing their inherent risks.  As Wall Street is quick to point out, past performance does not guarantee future results.       

Lawsuits, arbitrations and regulatory actions are on the rise against Wall Street firms for their active participation in the auction-rate securities market.  Many experts contend that Wall Street is going to have a tough time defending the impending flood of claims.

One reason why Wall Street is likely to be taken to task is that the firms were so actively engaged in this segment of the market.  The firms created these products as a way for municipalities, charities and others to raise money for long-term periods at short term rates.  Not only did the firms facilitate the creation of these products, they were a crucial player in the auctions themselves.

Prior to the last several months, in the event that interest in an auction was not sufficient, Wall Street firms would step in and make a market with their own bids on the securities.  This was an important characteristic of the auction-rate products.  However, recently when the credit crisis began causing the auctions to fail, Wall Street did not step up to the plate and make bids.  As such, they left investors holding these products with no market and left issuers paying higher interest rates.

According to a recent Wall Street Journal article, Auction-Rates A Legal Tangle, by Amir Efrati and Liz Rappaport, one reason Wall Street is facing such a nettlesome legal problem is because the victims in these cases are easy to identify and are more sympathetic than the institutional players who have suffered losses in other mortgage-related investments.

It is expected that more and more legal actions will be initiated as investors tire of waiting and hoping that the markets will once again become viable.  Now that many firms are no longer pricing these securities on customers’ statements, investors are taking action to protect themselves against loss and seeking to recover damages caused by the inappropriate marketing and sale of these securities.   

Effective today, Fidelity Investments has been notified by Interactive Data, its third-party pricing vendor, that they will discontinue evaluating approximately 1,100 student loan auction rate securities (ARS) and 26 asset-backed securities. 

What this likely means for investors is that their next monthly statement will reflect “N/A” for the value of their action rate securities.  This will come as a tremendous shock to many investors who had been told by their brokers not to worry about the frozen auctions because the value of their positions was still there, it was only unavailable for a time.  Now many investors are going experience their greatest fears, the value will disappear from their statements (and possibly from their portfolio).

For investors already on edge due to the auction rate markets freeze, they now will have to deal with the realization that these products are in fact not as they were sold.  They are not cash equivalents.  They are in fact risky investments that can and will cause significant losses to their holders.

Media reports regarding auction rate securities have been widespread over the last several months.  And although many investors were not happy that their investments were tied up due to the failed auctions, many believed that things were only temporary.  Wall Street and its brokers perpetuated these feelings.  Now the truth is coming out.

It is not just Fidelity clients who are likely to witness N/A on their statements.  Investors with auction rate securities at other firms are likely to experience the same fate.  For investors waiting to see what is going to happen in this market, the shock of seeing the loss of value from these positions should move many to action.

The best course of action for an investor concerned with the performance of their ARS is to contact an attorney.  Many cases have already been filed on behalf of investors whose securities have lost all or part of their value.  Clearly these investments were misrepresented to investors.  Now, unfortunately, the losses are being recognized.