Friday, August 22, 2008

ABCP and Auction-Rate Securities: A Tale of Two Justice and Regulatory Systems

Nothing makes my blood boil more than reading articles like this one from the Boston Globe. Many U.S. retail investors were wiped out and they are understandably angry that they were lied to about the safety of "auction-rate" securities:

"I didn't have a clue what an auction-rate security was,'' said Bert Davidson, a Lexington businessman who has had a large account with Fidelity for several years. But after a Fidelity representative described the securities as safe and cash-like, Davidson said, he decided to invest about $900,000 in them.

Now he can't access his money. Auction-rate securities nationwide have been frozen since February, when virtually all trading in the market shut down following a steep drop in investor demand.

And like thousands of others who bought auction-rate securities through brokerages across the country, Davidson's frustration level is mounting.

Canadian retail investors can empathize as many of them are embroiled in their own asset-backed commercial paper (ABCP) crisis.

But unlike in Canada, the legal and regulatory response in the United States has been much swifter and much harsher. An article from the LA Times this morning states that the auction-rate securities probe is expanding to cover over 40 brokerages.

I quote the following:

Regulators looking into the auction-rate securities debacle have turned their attention to nearly 40 brokerages that may have sold the paper to clients but didn't underwrite it.

Investigators from the Financial Industry Regulatory Authority plan to conduct on-site examinations at the brokerages, with the first inspections beginning Monday, to determine whether the firms were aware of the problems in the auction-rate market and adequately warned customers about the risks, according to a person familiar with the issue.

The regulatory sweep represents a major widening of auction-rate probes that until now have centered on the big investment banks that underwrote the debt and managed auctions of the securities.

On Thursday, three more Wall Street firms joined the list of companies agreeing to make amends with customers who bought auction-rate securities.

The addition of Merrill Lynch & Co., Goldman Sachs Group Inc. and Deutsche Bank brought to eight the number of companies that have reached legal settlements regarding the securities.

The eight firms -- including Citigroup Inc. and UBS -- have agreed to repurchase about $50 billion of roughly $60 billion in auction-rate debt estimated to be held by individual investors.

I am not surprised that the big Wall Street firms are in a hurry to settle now. Either they settle now or risk settling later for a lot more money.

The article goes on to state:

Auction-rate securities are long-term debt instruments that were designed to trade like short-term securities. They were issued by many municipalities and closed-end mutual funds in recent years, and were pitched by brokers to small investors as safe and easily redeemable.

When the credit crunch worsened early this year, the $300- billion auction-rate market froze, leaving investors unable to sell their holdings.
A bond-industry trade group representing regional brokerages has contended that they have no obligation to repurchase auction-rate securities, because they simply facilitated purchases at the request of clients and took no role in the creation of the securities.

However, a top lawyer in Cuomo's office sent a letter to the trade group Wednesday rebutting those claims. Benjamin Lawsky, a Cuomo special assistant, said Cuomo's probe "has already begun to uncover some disturbing facts that seem to belie the innocent picture of downstream brokerages." It seems "highly unlikely that the firms had no understanding of what was happening in the [auction-rate] market," Lawsky added.

Duh! They knew the risks but they saw a way to screw retail investors over.

The exact same thing happened here in Canada but the ABCP saga is just dragging on. It now looks like the ABCP case will head to the Supreme Court of Canada. The latest snag comes from Ivanhoe Mines Ltd., which is stuck with $70.7-million (U.S.) of ABCP and is now asking the top court to stop the planned restructuring.

I quote the following:

Ivanhoe is arguing that the restructuring is unfair because it gives all participants in the ABCP market broad immunity from lawsuits, and that the Ontario Court of Appeal ruling on Monday allowing the proposal to go ahead is flawed, said Howard Shapray, Ivanhoe's lawyer.

Purdy Crawford, head of the investor committee that created the proposal, said yesterday that the aim is still to try to complete the restructuring by Sept. 30. The plan calls for swapping the frozen notes for new bonds that trade freely.

"Ivanhoe's announced intention to seek leave to appeal does not affect our determination to complete the restructuring on our announced proposed timetable," Mr. Crawford said in an online chat on, adding that "if Ivanhoe (or any other party) takes any steps to delay the completion of the restructuring pending the Supreme Court's determination, we will resist those attempts."

The Supreme Court is fresh off a momentous decision in the BCE Inc. takeover, ruling in June that the $35-billion transaction could go ahead. In the ABCP affair, billions of dollars of value would again hinge on the court's decision should it agree to hear the case.

The proponents of the restructuring say that without the legal immunity that challengers such as Ivanhoe dislike, the plan would fall apart and all investors would suffer huge losses.

With all due respect to Purdy Crawford, I believe that Ivanhoe is absolutely right to appeal the Ontario Court's decision. Other legal experts agree with this decision and see it as one that is unlikely to be successfully appealed.

But granting legal immunity to the investment banks that sold this garbage to unsuspecting retail and institutional investors is setting a dangerous precedent. Legal immunity in this case is akin to granting them a right to screw over investors in the future.

What I do not understand is why the big Canadian public pension funds did not team up with all the other investors to sue the big banks and settle out of court. Diane Urquhart recently told me that government- related entities that she knows of own 58% of the $32.1 billion Non Bank ABCP. The total marked-to-market loss on the Non Bank ABCP under CCAA is $16 billion, so the government-related entities' share of this is $9 billion.

By taking writedowns on ABCP holdings, these government-related entities, which includes large public pension funds, are effectively passing the bill off to Canadian taxpayers.

Finally, take the time to read Harry Koza's excellent article on how auction-rate securities make for more pain on Wall Street.

I quote the following:

Well, if there's investor demand for anything, whether money market paper or tulip bulbs, you can bet that the Street will quickly invent some fiendishly clever instrument to fill it. Why not get those long-term borrowers to issue debt with the same final maturity of 20 years, but with a coupon that resets every seven, 28 or 35 days? You could hold a Dutch auction (which would accept the lowest yield that can clear the amount) to reset the interest rate at the end of each period. Investment dealers would handle the auction and provide liquidity by making a secondary market in the paper.

Investors would love the stuff because it offered a little extra yield over T-bills. As for the borrowers, well, since short-term variable interest rates are much lower than 20-year fixed rates, they'd save a bundle in interest costs alone. Plus, they'd diversify their debt portfolios.

Mind you, there are risks with this kind of thing. If interest rates started to rise, issuers would have higher interest costs, which could affect their projected cash needs and debt service costs. That kind of thing could hurt their credit ratings.

No problem, said the smart guys from Wall Street, we can, at a small additional cost, add a layer of bond insurance to provide a triple-A rating, and besides, we also have a veritable cornucopia of derivative products like interest rate caps and swaps to offset any risks. We've got it all covered, nothing can go wrong.

Well, okay then, said the issuers. And the investors said, send it in, we gotta have it. And so the ARS was born. A few years on, there's $300-billion (U.S.) worth of the stuff out there. Only, it's not just municipalities and other government borrowers issuing ARS. Collateralized debt obligations (CDOs) also took advantage of low short rates to finance their long-term (subprime) assets by borrowing in the ARS market.

Then the credit bubble burst. Oops, some (many) of those CDOs had some dodgy assets on their books. Double oops, some (okay, most) of the bond insurers were leveraged at triple-digit multiples of their capital and investors rapidly lost confidence that the credit insurance was actually any good.

When the ARS reset auctions came up, suddenly there were no bids. In just one week in February, more than 1,000 ARS auctions failed. The New York/New Jersey Port Authority sold $100-million of ARS paper and the auction clearing bid was a staggering 20 per cent, up from 4.3 per cent the week before. The dealers who were to provide liquidity in the paper, alas, already reeling under their other ill-fated alphabet soup adventures (structured investment vehicles, CDOs, etc.,), were unable to do so. Distraught investors were told that the ARS market was frozen and they couldn't get their money out. Liquidity guarantees? Surely, you jest?

So, $300-billion in ARS and the market for the stuff, like the Canadian asset-backed commercial paper (ABCP) market, remains frozen. Both of these acronymic instruments are similar: both are short term; both are triple-A rated and supposedly safe as houses; both are borrowing short to finance long-term assets; and both are causing all sorts of regret and recrimination for issuers, investors and intermediaries alike.

While here in Canada the courts are upholding the notion that cleaning up the ABCP mess must necessarily exempt its perpetrators from any possibility of civil litigation, in the United States, they're making the ARS perpetrators buy it back.

UBS alone - and man, that U must stand for ubiquitous, because lately it seems every time some new credit disaster happens, there it is - has agreed to buy back $19-billion worth of the stuff. Merrill and Citigroup are, between them, buying back another $20-billion or so. It's a long way from $300-billion, but it's a start.

The Street will likely be forced to eat more of the stuff, and there will be more big writedowns ahead, so it's probably not a good idea to buy any U.S. financial stocks just yet.

Wall Street firms are taking some solace seeing some large wealth funds, like the Government of Singapore Investment Corporation (GIC), rush to their rescue with fresh capital. But when all is said and done, these wealth funds are just prolonging the inevitable. Sooner or later, they will realize that the long run may be a very long time, especially if we hit debt deflation some time in the next couple of years.

More importantly, Canadian ABCP investors are anxiously waiting to see how the Supreme Court of Canada will rule on the case. It's too bad that our justice and regulatory system have miserably failed them thus far and I fear that it's only going to get worse. When it comes to securities laws and regulatory enforcement, we could learn a lot from our neighbors down south.

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