Capital Markets

Buyers Be Where?

Auction-rate securities are hitting businesses large and small in the wallet and on the balance sheet. The big question: If no one will buy them, w...
Alan RappeportApril 1, 2008

The headlines blared the news globally last week: Swiss bank UBS was writing down between 5 percent and 20 percent of its $5.9 billion exposure to the failing market for auction-rate securities. But for Bill Freeman’s small copy-machine company in Irvine, Calif., the $200,000 in those securities that UBS holds for him are an even bigger problem.

Those funds are frozen, and most likely worth much less now, at least for accounting purposes. And without some relief, Freeman may have to draw operating capital from his 25-employee company, Century Business Services, just to pay his taxes this year.

Like Freeman, may smaller holders of auction-rate securities did not even realize they were making a risky investment in the ARS market; auction-rates were marketed like savings accounts with slightly better interest rates. Auction-rate securities are long-term bonds and preferred stocks that resemble short-term instruments because their interest rates are reset periodically — usually every 7, 28, 35, or 49 days. The rate is reset by a modified Dutch-auction process, and because investors are supposed to be able to buy and sell the securities so frequently they are generally regarded as equivalent to cash.

“They told me it’s not a credit problem, it’s a liquidity problem,” Freeman tells “If I can’t make the payment on my Honda and try to explain that it’s just a liquidity problem, I’d be walking.”

These days, as the credit crisis has spread to some of the most arcane markets, auction-rate securities are nearly impossible to cash in, and holders are feeling their cash flows constrained. Freeman has another $550,000 locked up in auction-rates with Wells Fargo, which offered him an $80 credit on his checking account to switch his money from a savings account into securities that he was told would take a few days longer to liquidate. Freeman is frightened that big banks can just write-down his portfolio with little notice.

“I don’t know what basis they have for doing it,” Freeman says. “There’s no secondary market for these things.”

In an effort to find a market where a failing one exists, firms with electronic trading networks are now attempting to offer secondary markets for auction-rate securities that cannot be sold at auction. The UBS write-down comes as investors file lawsuits and regulators begin investigations into how securities that were billed “as good as cash” when issued now unredeemable. One of the problems that banks, companies and anyone holding auction-rate securities now face is how to account for what they are holding. In effect, what value does an asset have if nobody wants it?

“This is a security where people are losing money,” says Barry Silbert, CEO of Restricted Securities Trading Network (RSTN), which began allowing trading of auction-rates last month. “When all the dealers stopped supporting the auctions, we got calls from people who knew we had this secondary market for illiquid securities.”

The market is slowly growing, says Silbert, and has about 150 auction-rate securities for sale with about 100 secondary market buyers watching or placing bids. Silbert will not say how many transactions have taken place so far, but notes that the average discount on the transactions has ranged between 5 percent and 30 percent.

The Financial Industry Regulatory Authority, or FINRA, said Monday that holders of auction-rate securities may want to consider the secondary markets, although they are likely to receive less than par. Another use of the secondary market is valuation. Pluris Valuation has been working with RSTN to take data from transactions on its electronic market and calculate the current “fair value” of the security.

“We’re getting an awful lot of panicked calls from people who are not sure how to value these,” says Espen Robak, president of Pluris. “They want to know how much they’re going to have to write down for accounting and reporting purposes.”

One problem with such methods, and with such markets, is that liquidity remains thin. Silbert notes that the offers have declined this week as a result of the continuing bad news from UBS. John Craft, of the Muni Center, a municipal bond exchange, says that his firm’s foray into a secondary market for auction-rates has also been slow-going so far.

Secondary markets may struggle to take off, as those who can afford to hold on to their securities will likely wait until the auction market comes unblocked or their bonds age to maturity. For those needing cash right way, taking a big discount could turn out to be a solution as bad as the problem.

“In the long run it’s an outstanding idea,” Anthony Carfang, of Treasury Strategies, a consultancy, says of the potential for secondary markets. “But in the short run I don’t think large swaths of corporate America are going to want to revalue the entire $300 billion auction-rate securities market based on a secondary market.”

Carfang says that the fundamental problem with the current market situation is that the wrong types of investors are holding these securities. “These same securities buried in a pension plan or bond fund or insurance company portfolio would be great,” he says. The key is to get them into the correct hands so that demand ensues and the market revives itself.

“There’s no market because nobody wants to buy them,” says Harry Newton, an investment guru who has started the blog for rants from angry auction-rate investors. “Everyone’s bristling at UBS. They said they’ve got formulas to value these things, yet they won’t buy them back.”

Now Newton, who has $4.5 million locked up in auction-rates, is getting dozens of E-mails a day from angry victims like Bill Freeman, a businessman who is so cautious with his money that he paid for his home without a mortgage. “That was rainy day money, and with the economy right now, it’s starting to sprinkle,” says Freeman.

It may be small comfort that the precipitation appears to be just as heavy, or heavier, at the top. Days after announcing its auction-rate write-down, UBS revealed that it will write down $11.9 billion in debt securities and that Marcel Ospel, the bank’s chairman, would resign.