Auction rate security

The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in 1988, a $121.4 million financing for Tucson Electric Company by the Industrial Development Authority of Pima County, Arizona.

As bank loans became more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt.

Investment banks that participated in the distribution and marketing have agreed to repurchase around $50 billion in securities from investors, including municipalities, to resolve investigations by U.S. state attorneys general and the SEC.

Many financial services companies have been involved in packaging a collection of similar instruments, such as municipal bonds, into closed funds that were sold as both preferred and common shares.

Until 2008, broker-dealers would usually bid on their own behalf to prevent failed auctions from happening, as the commissions they earned from keeping the market functioning normally outweighed the occasional commitment of capital.

The SEC summarized its findings: "between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws."

The auction failures in February 2008 led to industry-wide freezing of clients' accounts while requiring municipalities to pay excessive interest rates, reported to exceed 20% in some cases.

A renewed investigation of the auction rate securities industry was led by Andrew Cuomo, the Attorney General of New York, and William Galvin, Secretary of the Commonwealth of Massachusetts.

However, auction-running broker-dealers are generally reluctant to facilitate secondary trading at a discount from par, due to the fact that in doing so they would necessitate markdowns to the value of other clients' holdings.

The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley, and Merrill Lynch) declined to act as bidders of last resort, as they had in the past.

The lawsuits were filed in federal court in Manhattan alleging that these investment banks deceptively marketed auction rate securities as cash alternatives.

[13] On August 7, 2008, in a proposed settlement of state and federal regulators' charges, Citigroup agreed in principle to buy back about $7.3 billion of auction rate securities it had sold to charities, individual investors, and small businesses.

The agreement also called for Citigroup to use its "best efforts" to make liquid all of the US$12b auction-rate securities it sold to institutional investors, including retirement plans, by the end of 2009.

The settlement allowed Citigroup to avoid admitting or denying claims that it had sold auction rate securities as safe, liquid investments.

Merrill Lynch's action created liquidity for more than 30,000 clients who held municipal, closed-end funds and student loan auction rate securities.

In August 2008, the Securities and Exchange Commission's Division of Enforcement engaged in preliminary settlements with several of the larger broker-dealers including Citigroup, JPMorgan Chase, Merrill Lynch, Morgan Stanley, RBC Group and UBS.

[15] In November 2009, JPMorgan Chase settled a lawsuit brought by the SEC over failed ARSs issued with Jefferson County, Alabama (Birmingham area).

[16] In his financial blog Sense on Cents, Larry Doyle referred to the marketing and distribution by Wall Street of auction-rate securities as "the single greatest fraud ever perpetrated on investors".

[19] For issuers, ARS appeared to offer low financing cost, in some cases more attractive than traditional variable rate demand obligations (VRDOs).

For buyers, ARS provided a slightly higher after tax yield than money market instruments due to their complexity with an increase in risk.

"[22] The valuation of auction rate securities has proved especially difficult as Bank of America and other brokerage houses refuse to assign a value to their clients’ holdings.