In September 2006, an SEC official gave a remarkably prescient speech to an obscure organization (well, obscure to me, anyway). Martha Mahan Haines, chief of the SEC's Office of Municipal Securities, presented a short speech to about 400 “women issuers, bankers, lawyers, trust officers, underwriters, analysts and other finance professionals,” according to the Women in Public Finance website.
In her speech, Haines said, “It is true that, due in large part to b/d intervention, there have been few failed auctions” in the auction-rate securities (ARS) market. But she noted, “The true liquidity risk, volatility and fragmented nature of this market was not made clear to issuers or investors.” She stated, given the fact that b/ds often intervened to set interest rates of the ARS directly or indirectly, “it may not be accurate to call this an auction at all.” Yet, the ARS market auctions grew to about $330 billion worth of securities, with everyone from municipalities to government agencies to closed-end funds using the market to borrow money (the rate of interest would be set at auction and reset frequently). But last year, broker/dealers worried about their own CDO losses, and in need of capital, began pulling out of the auction. And this year, the market has been largely frozen — most securities have been rendered illiquid for want of buyers.
Of course, like every other financial innovation, the ARS market worked its way down to the wealthy retail investor (the ante for participation was lowered to $25,000 in some cases). Financial advisors, trying to eke out a little extra yield, would park client cash in ARS, often in closed-end fund preferred stock. And therein lies the ugly tale that marks our cover this month. As Haines noted, ARS auctions rarely failed in the 20 years of its existence; advisors began to regard them as being as safe as a money-market fund — but yielding a few extra basis points in return. Advisors we spoke to said that's how management and analysts described the ARS market to them. They, and their clients, have since learned the hard way what Haines warned a couple of years ago: The ARS market shouldn't have been called an auction at all, that it is “fragmented by a high number of dissimilar offerings, a decentralized over-the-counter market structure, and a lack of transparency.” She said such facts needed to be “aired and discussed.” And because the interest rates were really controlled by the participating b/ds, ARS market products should not be called “auction rate” at all, but something else, she said. Haines suggested “managed auction process,” or, more simply, “bidding system,” to the assembly of women financiers. She noted that traders usually prefer nicknames … How about “BS Securities?” she wondered. Haines noted that such an acronym might not be appealing, but, in hindsight, her description was spot on. Please turn to page 32 for more.
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