April showers ended up watering not just the usual May flowers but a jungle of class-action lawsuits alleging malfeasance in the selling of auction-rate securities. No fewer than eight such suits were filed in May alone, according to the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research.
Briefly stated, an auction-rate security is a type of long-term bond issued by a corporation or municipal government. To attract investors, the bonds are put up for auction every seven, 28 or 35 days.
Investors like auction-rate securities because they provide a high degree of liquidity with a better return than money market funds, albeit with higher risk. Borrowers like them because frequent auctions tend to keep interest rates and fees low. That's the game when times are good in the credit markets, anyway.
When times are tough, as they have been recently, bond insurers that normally back such debt say, "No thanks." Brokers that would normally shepherd such bonds to market get cold feet.
On one now infamous day, February 7, investors like Citigroup, UBS AG, Morgan Stanley and Merrill Lynch, which represented a large part of the auction-rate bond market, began announcing that they were no longer going to serve as bidders of last resort.
The big brokerage houses, already suffering from losses in the real estate market, pulled back out of fear that the bond insurers that backed the debt were going to be downgraded.
And so the auctions began to fail, and the process of auctioning off these securities went into a deep freeze, at least temporarily, as buyers for these securities stampeded for the exits. When that happened, even with municipal bonds being at low risk of long-term default, investors looking for short-term results got edgy and fled for the courts.
Even the white-shoe brokerage houses were targeted in this last class-action wave relating to auctions that failed in February and March: Goldman Sachs Inc., Wells Fargo and Co., RBS Dain Rauscher, The Royal Bank of Canada, Oppenheimer Holdings Inc. and the E*Trade Financial Corp., among others.
Plaintiffs allege that the financial giants led them to believe auction-rate debt was just as liquid as money market funds and were as good as cash.
The lawsuits also allege that broker-dealers knew that the auctions were at risk of failing and that broker-dealers planned to withdraw their support of the market, while still telling investors that their investments were liquid.
Defendants have yet to respond to the allegations in court.
But as some in the blogosphere and elsewhere have pointed out, all the auction-rate bonds need to become liquid once again is for investors to step in and bid on them when they next come up for auction.
The question for the likes of Goldman Sachs and Wells Fargo is, whether they insure auction-rate securities themselves or buy such backing from bond insurers, will the bonds become liquid once again, and if so, will they be liquid in large enough quantities to appease investors and avoid huge liability losses.
"I would be surprised if the market for your instruments isn't already impaired to the point that you would have a hard time selling your paper. I hope I am wrong about that," is the way one investment blogger phrased it in mid-April.
August 1, 2008
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