Following hundreds of failed auctions, the market has now found itself frozen, leaving investors wondering if and when they will ever see their money again. The repercussions of the subprime meltdown have ultimately fueled a firestorm of damage on the $330 billion auction-rate securities market.
And while investors are left holding an empty bag, brokerage firms continue to get paid by the issuers of the bonds for holding auctions that fail. For example, as of mid-February, New York State reportedly paid 10 investment banks more than $600,000 to handle bids of auction bonds, even though the auctions failed and the state has paid higher penalty interest rates. The investment banks, which include Citigroup and Goldman Sachs, receive $10 million each year to oversee the auctions.
Auction-rate securities are long-term bonds that act like short-term debt, with floating interest rates that reset through a bidding process held every seven, 28 or 35 days. In the past several months, the market has witnessed a slew of failed auctions on a daily basis. During the last week of March 2008, auction-rate bond failures rose to 71 percent, with 2,023 out of 2,865 auctions failing.
Investment firms that handle the auctions, such as Merrill Lynch and UBS, used to step in and support the auctions if there were not enough bidders. No more. As a result, issuers of the bonds are forced to pay exorbitant penalties in higher interest rates, while investors are locked into investments they can’t cash out of.
Some borrowers, including the Dallas Ft. Worth Airport and Ascension Health in Missouri, are refinancing their bond debt as a way to avoid paying high penalty interest rates. The Dallas Ft. Worth Airport converted $337 million of auction debt into fixed-rate bonds at interest rates as high as 6.25 percent, which is still considerably lower than the penalty rates on some auction-rate securities.
As for investors, many who are stuck holding auction-rate securities believe they were misled by their brokers, and contend they positioned the investments as cash alternatives. On March 27, 2008 Massachusetts Secretary of State William Galvin announced that his office would take several investment firms to task on this very issue in an investigation into the practices used to sell auction-rate securities at UBS, Merrill Lynch and Bank of America.
Whether Galvin’s investigation provides an acceptable resolution is still up for debate. At the very least, it will hopefully signal the end of the free ride that so many brokerage firms in the auction-rate securities market have enjoyed.
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