When several Wall Street investment banks recently agreed to buy back billions of dollars of illiquid auction rate securities from investors, some closed-end fund firms that were first on the scene to bail out investors by redeeming their auction rate preferred shares (ARPS) are now wondering if they did the right thing.
Their puzzlement is because some closed-end funds resorted to using expensive lines of credit and syndicated bank loans to finance the redemptions of auction rate preferred shares for investors. Now, those funds could be facing potential financial issues of their own.
An Aug. 12, 2008 article in the Wall Street Journal highlights the dilemma confronting closed-end funds that that initiated plans on their own to help disgruntled investors get rid of their auction securities when the market seized up six months ago.
Auction rates securities are long-term bonds but act like short debt, with interest rates that reset at auctions held every seven, 14, 28 or 35 days. Issuers of auction rate securities include municipalities, student loan companies and closed-end funds, the latter of which uses preferred shares in auction bonds to provide create higher returns for common shareholders.
Following the collapse of the auction market in February, investors holding auction rate preferred shares, or ARPS, found themselves in the same boat as thousands of other auction rate investors: unable to access their cash. Some closed-end funds, including Nuveen Investments, Black Rock and Eaton Vance, were quick to address investors’ concerns about their illiquid, auction rate preferred shares and voluntarily began developed redemption plans. Other closed-end funds simply have waited it out.
At the start of 2008, closed-end funds had about $64 billion of auction rate securities outstanding. Now, the figure is closer to $40 billion, a 37% decline, including what various closed-end funds have said they plan to redeem, according to an Aug. 11 article in Barron’s.
Such help could come at a cost for a few funds, however. As reported in the Wall Street Journal article, some of the auction-rate preferred issued by closed-end funds were pitched by Wall Street investment banks - many of which are the same banks at the center of state and federal investigations for marketing auction rate securities to clients as cash-alternative investments. Last week, Citigroup, UBS and Merrill Lynch agreed to buy back nearly $40 billion in auction rate securities. The settlement offers are expected to create a template for other firms to make amends with auction rate customers and resolve alleged claims of auction rate deception.
The recent turn of events means closed-end funds that waited on the sidelines rather than seek alternative or expensive forms of financing to help their investors out of auction-rate preferreds might be better off now financially. Meanwhile, the auction rate scandal continues on. On Aug. 11, 2008 New York Attorney General Andrew M. Cuomo announced that his office is expanding its investigation, and notified JPMorgan Chase, Morgan Stanley and Wachovia that he will be looking into the their behavior and whether the firms sold auction rate securities to investors as safe, cash-equivalent products, when in fact the market was headed for disaster.
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