Auction Rate Update

I haven't done an update on the auction rate security mess for quite a while, but now that some firms are starting to settle with their clients, it seems a good time to review.

The large brokers of auction rate securities, who were also the underwriters, have all mostly agreed to buy back auction rate securities from their clients. This was forced by Andrew Cuomo, the AG of the state of NY. Other state AGs have also been active in pursuing settlements. So if you are a client of Citigroup (Smith Barney), Merrill Lynch, UBS or JP Morgan, you will be getting your money back, probably by the end of the year - well that depends. It may be this year or more likely next year but possibly not until 2010. If you are a client of a smaller firm that wasn't among the underwriters, you aren't so lucky - yet.

The AGs forced these settlements by concentrating on the marketing of these instruments, which they said was fraudulent. Auction rates were sold as money market alternatives and clients were told that these were liquid instruments. That turned out not to be true and the firms were facing multiple lawsuits and arbitrations which they would likely lose.

Smaller firms used the same marketing tactics but have not joined the settlements for a variety of reasons. First, they probably don't have the money. Second, they can claim that they were depending on the underwriters to maintain a market and that they were victims as well. My guess is that the solution for the smaller firms will include admitting some guilt on their sales practice, but the underwriting firms will take the majority of the blame.

There is one other class of firms that really shouldn't be included in a settlement. Discount firms that didn't actively market the auction rates should not be held liable. Firms like Fidelity and Schwab were not out soliciting clients to invest in these things but just made them available. As such they really didn't do anything wrong. Full Disclosure: My firm uses Fidelity as our primary custodian.

That hasn't stopped the state of MA from pressuring Fidelity to buy back the securities:

NEW YORK (MarketWatch) -- After reaching deals with many of the top Wall Street banks over the auction-rate-securities mess, regulators are now turning their focus on brokerage firms not covered by those agreements.

Massachusetts Secretary of the Commonwealth William Galvin has written to Edward "Ned" Johnson, CEO of Fidelity Investments, asking that Boston-based Fidelity buy back the auction-rate securities that it sold to its clients.
"It is my hope that Fidelity will follow the industry trend and promptly repurchase these securities that it has sold to it customers, many of whom now find themselves unable to access money that they thought was as liquid as cash," wrote Galvin.

"Therefore, I request that Fidelity take immediate steps to resolve this matter on behalf of those customers."

Fidelity obviously does not agree:

Fidelity, though, stood firm in the face of Galvin's letter. "Fidelity is [not] the issuer, underwriter or sponsor of auction-rate securities," said Vin Loporchio, a spokesman for Fidelity. "We do not proactively market auction-rate securities. We believe the underwriters should stand by their securities."

I think Fidelity is right on this and the state would have a very hard time convincing a jury that Fidelity is liable.

One mystery is where the banks are getting the money to buy back these securities. They are already facing significant capital impairments from mortgage and private equity debt and would seem to have limited access to capital to use for this. Will the Fed be accepting auction rates at the discount window? I don't know but my guess would be yes. This will probably also force the issuers of auction rates, primarily fund companies like PIMCO, to come up with a solution. The banks cannot just carry this illiquid stuff on balance sheets already gummed up with illiquid mortgages. Expect to see signficant pressure on the fund companies to replace these and pay back the brokers/bankers.