“Like a Moroccan bazaar” was how William Galvin, Massachusetts’s secretary of state, described the market for auction-rate securities (ARS), whose collapse has left thousands of investors stuck with debt they had assumed they could easily sell. But there is a difference. Getting a stallholder in Fez to take back damaged goods is a tall order. Banks, on the other hand, have moved quickly under pressure to buy back the paper they flogged, in what looks like the biggest-ever forced bail-out of Main Street by Wall Street.
In normal markets, auction-rate debt looked highly seductive. With the interest rate reset weekly or monthly in auctions, cities, student-loan trusts and the like could issue long-term debt while benefiting from lower short-term rates. Buyers got a near-cash product that paid higher yields than money-market funds. Brokers typically creamed off up to 0.25% of a market that swelled to $330 billion by last summer. When demand began to subside late last year, dealers bought the debt themselves to prevent auctions from failing. But most pulled out in February as the failures became endemic. New York’s Andrew Cuomo and other attorneys-general took up the cudgel—in an echo of Eliot Spitzer’s post-dotcom crusade. UBS, Citigroup and Merrill Lynch have agreed to buy back more than a combined $41 billion of ARS and pay at least $250m in fines. JPMorgan Chase and Morgan Stanley were reportedly close to a settlement on August 13th.
The banks cannot claim to be wholly innocent. At best, they were not completely honest with clients about the need to prop up the market. State officials have unearthed some embarrassing e-mails. One indicates that a Merrill Lynch researcher was told to soften a report on the dangers in the ARS market. The head of UBS’s auction-rate desk offloaded his personal holdings of ARS even as the bank was selling the product to clients.
But did mis-selling take place on a grand scale? Bankers say they supported the market not to deceive investors but in the belief that they could keep it afloat until it recovered. They took their lumps themselves: UBS’s holdings of auction-rate debt almost doubled, to $11 billion, between December and February. “We genuinely misread the market,” says one banker. To some, Mr Cuomo’s aggressive stance has more to do with political ambition than financial fairness.
Moreover, the risks were disclosed. Marketing documents spelled out the possibility that auctions could fail, and that dealers were not obliged to step in on clients’ behalf. Many of the 100,000 or so retail investors were well-to-do types and thus clued up enough to understand that higher yields suggest higher risk. Some clearly displayed “credulity bordering on avarice”, says James Cox, a law professor at Duke University. Many clung to their paper despite having several turbulent months to cash out.
The settlement terms are certainly harsh. Not only must the banks reimburse all retail investors, but they will also offer interest-free loans to those who are short of cash in the meantime. Controversially, the states are also pushing for relief for some institutional investors, such as pension funds. That raises troubling questions about bailing out sophisticated buyers—especially since the problem was a lack of liquidity, not a flaw in the product itself.
The direct cost to the banks is manageable, since the paper they are taking back has a value. UBS, for instance, expects the hit to be less than $900m, small beer compared with its write-downs so far. But taking debt back onto their balance-sheets will leave banks even more strapped for capital, and even less eager to lend.
Nor is this the end of their legal woes. The strained Alt-A mortgage market alone is worth some $2 trillion. Grace Lamont of PricewaterhouseCoopers, a big accounting firm, thinks banks’ shareholders could even start to sue them over moves such as the ARS buy-back. No wonder that, as one lawyer puts it, bankers are “almost starting to yearn for the Spitzer era.”