Auction Rate Securities (ARS)–in the news again

what they are

Auction-rate securities are a type of variable rate financing invented by Lehman, popularized by Goldman and used mostly by charities and governments.  The idea was to sell long-term bonds, but pay interest on them at (much lower) short-term rates.

Periodic auctions, of the type the US Treasury uses to set the coupon on its bonds, but conducted by the brokers who sponsored the offerings were the means for performing this magic trick.  Auction periods varied, but would typically be either weekly or monthly.

The issuer would sell uncollateralized bonds with a long term–even 20 or 30 year–to an initial set of investors at a fixed interest rate.  At each auction, the holder would in theory either decide to keep the bond until the following auction, and collect the interest determined in the auction, or sell it to someone else, who would take his place.   Because the presumed ARS holding period was either a week or a month, ARS interest rates would arguably not be much higher than money market or commercial paper rates.

The marketing pitch to issuers was that they got 20-year money but would pay a very low rate.  Buyers were told that, although these were in fact long-term bonds, one should look at them as pretty much like cash but with a higher-then-cash yield.

ARSs differed from the Variable Rate Demand Obligations that this kind of issuer might otherwise use, in two main ways:

–ARSs have no put feature, that is, no way to return them to the issuer for payment at par (the auctions were supposed to provide all the liquidity holders would need);

–ARSs were cheaper to issue, with most of the fees going to the broker running the auctions, rather than to a bank, as was the case with VRDOs, for a letter of credit to make sure the put feature could be exercised.

Most ARSs were rated AAA, not necessarily because the underlying credits were this strong, but because the issue purchased insurance from one of the large monoline municipal insurers.

what happened

In early 2008, auctions started to fail, that is, not enough buyers showed up to absorb the bonds that existing holders wished to sell.  In hindsight, it’s not clear how much third-party demand there was at the auctions versus how much of the activity was done by the sponsoring brokers.

This had several (bad) consequences:

–the interest rates the issuers had to pay for the ARSs skyrocketed;

–holders began to realize that these instruments had become highly illiquid;  the bond prices also fell.  So much for “just like cash”;

–everyone sued.

why are ARSs in the news again?

It may be just a coincidence, but two revealing stories about the ARS fiasco have just popped up.

1.  Thomas Weisel Partners, the last of the line of Silicon Valley technology boutique investment banks, is being accused of securities fraud in connection with ARSs, according to the Financial Times.  (Actually, I was originally going to use Weisel as a jumping off point for talking about the fleeting phenomenon of the San Francisco area tech boutiques, but thought that ARSs, as a crazy bull market kind of security that made no sense but everyone bought into, was more interesting.)

Weisel reportedly was advising clients to sell ARSs early in 2008 over fears market liquidity would soon disappear.  At the same time, in order to raise money for executive bonuses, it allegedly removed $15.7 million from three clients’ accounts without their knowledge or consent and replaced the money with ARSs it had tried–and failed–to sell on the open market.  Weisel asked the clients to okay the transactions after the fact, but were refused.

2.  Gretchen Morgenson (a name that makes CEOs shudder) detailed yesterday in the New York Times instances where Goldman Sachs has acted in an ethically dubious fashion–like helping Washington Mutual resell packages of sub-prime mortgages while simultaneously shorting the company’s stock.

In the same article, she recounts the experience of the University of Pittsburgh Medical Center, a non-profit, with ARSs that Goldman helped it issue.  In mid-January 2008, UPMC became worried about ARSs and asked Goldman whether it should withdraw from the market.  Goldman told UPMC to “stay the course.”  But a few weeks later, Goldman itself fled the ARS market.

Because interest rates on the UPMC ARSs rose sharply, UPMC decided to redeem the securities.  Of the three ARS sponsors UPMC employed, only Goldman refused to allow the redemption to occur.   And Goldman continued to collect fees even though it was no longer sponsoring the auctions that the fees were supposed to be payment for.

So, take out your pencil and add ARSs to the list of zany bull market securities that sounded good while the champagne was flowing but had little investment merit.  Maybe between hybrid bonds and contingent convertibles would be a good place.

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