Capital Markets

Liquidating Frozen Auction-Rates

The market for auction-rate securities remains largely stuck, but a secondary market is slowly budding.
Alan RappeportApril 29, 2008

The frozen market for auction-rate securities is showing a few signs of thaw in a new secondary market, as transactions are slowly starting to pick up pace for those needing to cash out

The Restricted Securities Trading Network began listing auction-rates last month on its electronic trading network. Transactions were slow to begin but now average between seven
and 10 per day, according to Barry Silbert, CEO of RSTN.

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. However, the $330 billion market has become a cash-trap in recent months as the auctions became a victim of the credit

According to Silbert, 700 RSTN members, mostly hedge funds and institutional investors, have expressed interest in purchasing auction-rates. So far more than 170 are listed, with par values ranging from $25,000 to $40 million. One concern with the secondary market has been the discounts investors would incur on

To date, municipal auction-rate securities are seeing discounts of up to 10 percent on RSTN. Auction-rate preferred securities are between 10 percent and 20 percent. And student loan auction-rates are 25 percent and up.

RSTN has seen the fewest number of student loan transactions so far because holders have been unwilling to take large discounts on them. Silbert says these securities have the lowest chance of a refinance in the short-term because issuers pay low interest on them and don’t generally have capital to restructure them.

One investor, writing on the website , said the process of liquidating his $300,000 face-value holding on the secondary market took about one month. RSTN found him a buyer within three weeks, after negotiations he took a loss of 18 percent, and within a few days he had his money.

“It was unpleasant to take the loss, but at least now I have the cash to invest in other things,” writes the investor, Tom Hoffman. He adds, “The idea of the ARPS auction process returning to ‘normal’ is a complete fantasy.”

Meanwhile, funds and banks that issued auction-rate securities and marketed them as equivalent to cash are facing increased scrutiny from regulators and litigation from investors. Last week Barney Frank, chairman of the House Financial Services Committee, and Paul Kanjorski, chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, prodded the Securities and Exchange Commission to take action.

In a letter to SEC chairman Christopher Cox, Frank and Kanjorski questioned whether brokers who sold the securities
“did so using deceptive or misleading practices.” They also recommended that SEC quickly give mutual fund companies temporary relief from the regulator’s asset-coverage tests so they can redeem some of the illiquid securities.