Auction-Rate Securities: Still Frozen in Time

With the stock market trading near all-time highs and the economy chugging along, the credit crisis of 2008 is a fading memory for many investors—but not for those whose money is still tied up in auction-rate securities. Before the market froze in 2008, there were $330 billion of auction-rate securities outstanding. These long-term debt and preferred-stock instruments, with interest rates that reset regularly, typically were sold as alternatives to money-market holdings. Brokers, who sold them on behalf of issuers including mutual funds, student-loan trusts, and others, led buyers to believe they were liquid and could be sold at auctions, typically held every seven to 30 days. That turned out not to be the case. Seven years later, some $50 billion of ARS, held mostly by institutions, are still outstanding, with most auctions failing repeatedly. Some securities, yielding 0.5% or less, could remain outstanding for another 10 to 20 years. About 50% of ARS were sold to retail investors; the rest were acquired by institutions and corporations. Brokers quickly bought back most ARS owned by retail investors with under $10 million in assets after regulators and the attorneys general of New York and Massachusetts made claims of inappropriate sales practices. Retail investors with Oppenheimer Holdings (ticker: OPY), however, still hold $134.2 million of auction-rate securities, according to the firm’s annual report. Oppenheimer’s 2010 settlement with the aforementioned attorneys general allows it to repurchase auction-rate securities based on its excess capital levels. If the firm had to repurchase the securities in a short period of time, the outlay would have had a materially adverse effect on its operating results and financial condition, the annual report states. Officials at Oppenheimer and the New York attorney general’s office didn’t return calls for comment. Some corporate buyers continue to hold the securities. Southwest Airlines (LUV) disclosed in its latest annual report that it held auction-rate securities valued at $27 million, and Medtronic (MDT) said it owned ARS that cost $109 million. AS BARRON’S PREDICTED in a 2008 story, most auction-rate issuers have repurchased the securities they sold (“The Sad Story of Auction-Rate Securities,” May 26). Many mutual fund companies, including BlackRock (BLK) and Nuveen Investments, whose closed-end funds had issued ARS, quickly redeemed most or all of them at full value. Some student-loan ARS were paid back as the loans were repaid. Some other issuers, however, have offered to repurchase the securities only at a discount. The Pimco Corporate & Income Opportunity fund (PTY) tendered in February for its auction-rate preferred shares, but at 87% of face value. A Pimco spokeswoman referred to a Pimco regulatory filing stating that the price is fair to the fund’s common shareholders while offering the preferred holders liquidity. And some issuers haven’t offered to repurchase ARS at all. About 11%, or $16 billion, of the auction-rate securities sold by municipalities are still outstanding. Another 10%, or $8 billion, of securities sold by closed-end funds remain in investor hands, and 20%, or $17 billion, sold by student-loan trusts are still outstanding, according to Brendan O’Connor, managing director of the trading division of SecondMarket. Auction-rate securities sold by collateralized-debt-obligation trusts and certain other issuers have seen the fewest redemptions on a percentage basis. Just under half, or $7 billion, remain outstanding and are the least likely to be redeemed. Meanwhile, the majority of auctions for these securities continue to fail, due to insufficient investor interest. Last Thursday, for example, 22 of 37 auctions for municipal and student-loan ARS failed, according to EMMA, a public database. WALL STREET BROKERS owned a large amount of auction-rate securities after settling with the attorneys general following the credit crisis. Bank of America (BAC) still held $1.1 billion of ARS at year end, according to its annual report. Morgan Stanley(MS), Goldman Sachs (GS), and Citigroup (C) don’t disclose how much remains on their books, implying that the securities have all been sold or the holdings are no longer material in size. Officials at the firms declined to comment. “Many broker-dealers appear to have been successful in persuading municipal issuers to redeem the auction-rate securities at full value, thereby solving their problem and getting billions of dollars of securities off their balance sheets,” says Joseph Fichera, CEO of Saber Partners. Investors also can turn to the secondary market for liquidity, but it is likely they will suffer losses of 5% to 15% on student-loan and muni securities, says Espen Robak, president of Pluris Valuation Advisors. The loss increases sharply if the security was sold by an unusual issuer, such as a CDO, or has credit-quality issues. “It’s still a very active market for us,” says O’Connor at SecondMarket, which traded just north of $1 billion of auction-rate securities last year. Hedge funds and life-insurance companies reportedly have been buyers of ARS—at the right price. Investors in auction-rate securities sold by student-loan trusts can continue to hope that they will be redeemed as the loans are repaid. But other issuers inclined to repurchase securities at full value have already done so. Investors unwilling to sell at a discount might find they still own auction-rate securities for many years to come.