In response to the collapse of the auction-rate securities market, many investors are left questioning what to do next about their illiquid holdings. Investors should realize that there is not one correct solution that all auction-rate securities investors should follow. Whether investors decide to sell their securities or wait for the market to improve, here are some key points that investors should take into account when making their decision: 

Trends in the Market 

Some of the top brokerage firms agree that the auction-rate securities market has little hope of recovering, but some investors have had their securities refinanced. According to a June 6th Bloomberg article, municipal issuers either made plans to refinance or refinanced about $76.1 billion of auction-rate securities. In addition to municipal auction-rate securities, some investors have also been redeemed for their auction-rate preferred stocks. Although additional refinancings are expected to occur, investors should be aware that not all stock issuers are willing to refinance auction rate securities. Some issuers have decided to not refinance while others have only refinanced portions of their investors’ losses.  

Student loan auction-rate securities, which constitute $85 billion of the market, are among the most illiquid and unlikely to be refinanced. According to a July 10th Bloomberg report, less than 4% of student loan auction-rate securities have been refinanced so far. This is because issuers are not charged high penalty interest rates when auctions fail, leaving them little incentive to refinance. Auction-rate securities issued by CDOs, or Collateralized Debt Obligations, are also highly illiquid.   

Weighing Options 

When investors face the decision of what to do next with their auction-rate securities, factors such as liquidity and future expectations should be taken into consideration. For example, investors who do not want to risk their securities in the market any longer and need liquidity in the near future may choose to sell rather than wait. Or, investors who do not need liquidity any time soon and their issuer is being charged penalty interest rates should consider waiting rather than selling. Investors should learn what their issuers’ future plans are for refinancing. In addition, other resale markets are available where investors can dispose of their illiquid auction-rate securities. There is no guarantee, however, that this market will be successful in the future. So far, only one private market has had successful dispositions of illiquid auction-rate securities: Restricted Securities Trading Network (to learn more, visit http://www.restrictedsecurities.net/).  

Finally, investors should decide whether or not they are going to take legal action against their issuer to recover their losses. If so, then it is in the best interest of investors to take action as soon as possible rather than waiting to file a claim so they do not risk reducing the amount of damages they can recover.   

To Sell or Not to Sell? 

Investors could see many advantages to selling their auction-rate securities. First and foremost, investors receive liquid cash from selling and avoid the stress of worrying about future harm to their investments that could occur in the unpredictable market. Also, investors are able to better pursue legal action because they have made an effort to reduce their damages upon discovery of their investment losses.  

Investors can benefit from waiting because they could potentially be refinanced from their issuer. If an investor is refinanced, he or she no longer has to worry about lawsuits or illiquidity. Also, selling one’s auction-rate securities immediately will usually not earn an investor the face value of their investments. Waiting to sell avoids this discount problem. 

Evergreen Investments, the mutual fund operation and money-management unit of Wachovia Corp., will soon get a fresh start. The company announced Tuesday that Chief Executive Dennis Ferro will retire at the end of this year, just five years after assuming the position. Peter Cieszko, Evergreen employee since mid-2006 and current head of global distribution, will be his successor.  

In August, Evergreen Investments also plans to fill the abandoned chief investment officer position with David Germany, a former investment manager for Morgan Stanley. Ferro was the interim fill in after former CIO Chris Conkey unexpectedly left last year.  

Wachovia seems to be following in the footsteps of Evergreen with “top-level” struggles. The bank’s CEO G. Kennedy Thompson was ousted last month due to substantial losses and write-downs. These leadership changes come in the midst of struggles for Evergreen.

In the past year their funds’ mortgage- and asset-backed investments have been overwhelmingly troublesome.  Wachovia was forced to step up and buy such securities from Evergreen’s money-market funds to prevent them from breaking the buck - - when their net asset value per share falls below the $1 money market standard. The bank also reported a loss of over $40 million on the asset-backed securities purchased from Evergreen’s money funds.  

Last month, Evergreen was forced to liquidate one of its bond funds, Evergreen Ultra Short Opportunities Fund, because it lost half of its value in a mere six months due to subprime mortgage investments.

Evergreen’s closed-end funds, like many others, have suffered from the auction-rate preferred securities they issued. The investors of these securities were unable to withdraw their money when the market froze up in February.  

Mr. Cieszko claims the main reason for the mutual-fund investor evacuation is that, in recent years, Wachovia’s wealth-management unit started using non-Evergreen funds. Some Evergreen funds were even removed from of the Wachovia wealth-management operation since they were not “top of class”. According to a July 8, 2008 Wall Street Journal article by Shefali Anand, Evergreen’s mutual funds have had net outflows of nearly $10 billion since beginning of 2008. It now has $41.5 billion in fund assets and manages $258 billion overall.

Citigroup Inc., the bank with the largest reported losses due to the mortgage market collapse, is expected to take an additional $8.9 billion in net writedowns for the second quarter. Citigroup is already staggering from the $42.9 billion defeat in credit related losses. 

Goldman Sachs Group Inc. has lowered its ratings for U.S. brokerages from “attractive” to “neutral”, because the deterioration rate of the industry appears to be far worse than they originally believed. Goldman also slashed Citibank’s six-month price target to $16 and put the bank on its “conviction sell” list, after it closed at $18.85 in trading last week. Citibank has dropped about 16% this year. 

Goldman sees more struggles in the near future for Citigroup. Cathy Chan reported in a recent Bloomberg article that Goldman expects the bank to face risk of further writedowns, higher consumer provisions and the potential need for additional capital raisings, dividend cuts or asset sales. Goldman is not alone in these forecasts for Citigroup. UBS AG and Merrill Lynch & Co. also predicted more writedowns. Merrill Lynch analyst Guy Moszkowski believes the bank will report another $8 billion of writedowns this year.  

Citibank CEO Vikram Pandit announced an additional 13,000 job cuts this year. He also expects “substantial” additional writedowns and more losses on consumer loans. Goldman believes Citigroup may writedown $7.1 billion of collaterized debt obligations and associated hedges, as well as $1.2 billion for other asset classes. They also said the bank may need to post a $600 million loss to reflect the market-to-market value of its own structured note liabilities.  

It is unlikely that Citigroup will be able to keep its current 7% dividend yield, and they need to make more capital. It’s estimated they could generate $3.5 million in capital a year by cutting payouts in half.

Chief executive officer of Wachovia Corp., Kennedy Thompson, has stepped down (at the board’s request) after being blamed for losses costing the lender more than half of its market value this year. Thompson’s departure comes less than a month after his title was officially removed, making him the latest CEO to be ousted during the housing market chaos. Chairman Lanty Smith temporarily replaces him as CEO and Ben Jenkins is the interim chief operating officer.

Thompson’s title was removed after the annual meeting in April where shareholders, upset with the company’s first quarterly loss in seven years, requested his termination. Wachovia’s stock fell four percent and their shares dropped over 40 percent this year.

Even before his removal, Thompson’s standing with Wachovia was feeble. He recently admitted Wachovia’s $24 billion acquisition of Golden West Financial Corp. in 2006, in hopes to expand business during the housing boom, was “ill-timed”. The increased mortgage defaults and write downs due to subprime home loans caused the fallout.

Thompson slipped up again early this May. According to David Mildenberg and Hugh Son in their Bloomberg.com article Monday, the bank reported a first-quarter loss of $708 million, 80 percent more than Wachovia previously reported, due to the write-downs for bank-owned insurance policies. As a result, the bank had to cut its dividend by 41 percent and raised around $8 billion in new capital.

Wachovia formed a four-person search committee headed by Smith to find a permanent replacement for Thompson. Many wonder if his removal means more problems for Wachovia. The company has suffered a serious of setbacks, including their recent losses and investigations.

Washington Mutual Inc. seems to be on a similar path. They reported yesterday CEO Kerry Killinger was also stripped from his CEO title. The recent changes in many companies are occurring due to the credit losses from the current housing crisis and $386 billion in asset write downs.

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.

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.   

Bloomberg is reporting that Standard and Poor’s has lowered its assumptions for how much money investors will recover after defaults of mortgage related collaterized debt obligations.  Many view this as a sign that S&P may be preparing to add to the record number of downgrades already present.

Mortgage-linked CDOs have been the biggest source of more than $320 billion of asset writedowns and credit losses since the beginning of last year.  These writedowns have come primarily from classes once rated AAA or Aaa. 

According to Brian James, a partner at Link Global Solutions, “further rating-agency action will cause banks who hold hte majority of AAA bonds to re-evaluate their strategy.  So far they have been more comfortable writing down their positions in hopes of better recoveries.”

A statement released this week from S&P announced that the most senior bonds from CDOs originally rated AAA should recover 60 percent of principal owed, while securities rated A or lower will get nothing.   

One possible outgrowth of these reductions could be an increase in a secondary market where holders are forced to entertain the bid side of the market. 

According to S&P, their structured-finance ratings only reflect the odds that investors will receive timely interest payments and the return of their principal by the debt’s maturity date. 

The Wall Street Journal is reporting that Merrill Lynch & Co. is expecting to announce $6 billion to $8 billion in new write-downs this week.  This would bring Merrill’s total write-downs since October to more than $30 billion.

The write-downs have been caused (largely) by the subprime, CDO and credit crisisses.  But what is most interesting about the latest WSJ piece is that it appears Merrill was continuing to create new mortgage securities well after the risks of such securities were known.

It can be argued that Merrill was so taken by the large profits being generated by the creation of these new securities that even after it had become common knowledge that the risks of these products were greater than anticapated, Merrill did not relent in packaging and selling these securities to investors.  Now the SEC is investigating whether Merrill should have told investors earlier about the failing mortgage business.

The average individual investor can learn quite a bit from this story.  Namely, Wall Street and its brokerage residents often work in a vacuum.  They are all too frequently blinded by short-sided profit motives.  How else can one explain why Merrill Lynch kept digging itself into a subprime hole well after the hole began flooding?        

In an article in today’s Wall Street Journal, Liz Rappaport and Karen Richardson report that securities tied to student loans might be succumbing to the credit crunch.

The Wall Street players that bundled and sold investments in subprime mortgages also packaged student loans into similar investments.  According to the WSJ, auctions of these securities conducted by Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and Citigroup Inc. have failed to generate investors’ interest, leaving roughly $3 billion of securities without investor buyers.

In the past when demand was weak, the banks would step in and purchase the shortfall.  However, given the recent events relative to the subprime collapse, banks are already overburdened with other types of investment products they are trying to get off their books.  As a result, the auctions for the student loan products are failing.

These failures serve as an indicator that investors are growing reluctant to invest in these complex products tied to loans.  The fear is that valuing these products is difficult and that, like the subprime loans, these products will too experience declines in value.

When these auctions fail, the securities are left in the hands of investors who already hold them.  The result is that interest rates get reset.  The impact of this financial phenomenon is that students will likely see higher costs associated with their loans.

As this story illustrates, the fallout from the creation of complex securities by Wall Street continues to trickle down to Main Street.  It would appear that no credit program is beyond the reach of the current crisis.