Fed’s Lending Facility May be the Answer to ARS Buybacks

During normal circumstance, the Federal Reserve’s Primary Dealer Credit Facility (PDCF) is supposed to serve as a lender of the last resort’ - intended to keep the country’s financial markets functioning properly by providing loans to securities firms at a discount.

Now the Fed’s facility could be tapped for an entirely different purpose: lending money to investment banks that are buying back illiquid auction rate securities (ARS) from investors.

According to an August 11, 2008 article on Bloomberg.com, some analysts predict that Wall Street banks will turn to the Fed and its discount interest rates to finance the billions of dollars in auction securities they’ve agreed to repurchase, even using some of the ARS paper as collateral. Ultimately, banks might borrow upwards of $100 billion from the Federal Reserve, according to the article.

Last week, Citigroup and UBS became the first two firms to pony up approximately $30 billion to buy back auction rate securities from investors, as well as pay $250 million in fines. Merrill Lynch voluntarily announced its own auction rate plans shortly thereafter, agreeing to purchase $10 billion of the securities.

For the past five months, New York Attorney General Andrew Cuomo has led a nationwide investigation into the February collapse of the auction rate securities market, targeting Wall Street firms that allegedly deceived investors about ARS liquidity risks.

On August 11, 2008 Cuomo turned up the heat on his investigation by strongly encouraging three major underwriters of auction rate securities – JPMorgan Chase, Morgan Stanley and Wachovia Corp - to take immediate actions to resolve investigations into their auction rate securities sales. Later that same day, Morgan Stanley agreed to repurchase some $4.5 billion of auction rate securities from investors.

The offer, however, was disregarded by Cuomo, who called it too little, too late. Reportedly, Cuomo, along with multiple state regulators and the Securities and Exchange Commission (SEC) are close to reaching a settlement with a number of other banks.