The most interesting portions of the article, to me, were the relatively new information about this type of securities, and Lehman's suspect actions in putting a client in them.
According to the Journal article,
"The Mahers rank among the earliest victims of "auction rate" securities, a once-obscure type of bond now sending shock waves through broad swaths of the U.S. economy. Auction-rate securities -- an unusual type of long-term bond that behaves like a short-term bond -- have become a keystone of modern finance. They are routinely used to fund everything from college student-loan programs to municipal road-and-bridge projects.
These bonds became popular with investors looking for cashlike investments, because they offered better returns than traditional money-market investments but were just as easy to buy and sell.
Recently, however, that advantage has disappeared. The market for auction-rate securities has dried up amid fears about fallout from the subprime-mortgage crisis. This week, New York's Port Authority saw the interest rate on some of its debt jump to 20% from 4.2% amid disruptions in this market."
From what I can deduce from this, auction-rate securities have their interest rates reset by market-auctions, rather than, like a long-term bond, simply carry a fixed or variable, according to some index like LIBOR, rate.
Thus, the price of the securities which, of course, varies inversely with the yield, can plunge if, for some reason, the auction reset results in a very high interest rate being paid to new buyers of the debt. This is evidently what happened to the Maher's Lehman-based holdings.
The Journal article goes on to report,
"The brothers have filed a claim against Lehman, saying it mismanaged their money. The complaint, filed last month with the Financial Industry Regulatory Authority, which resolves disputes between investors and brokers, says Lehman ignored the Mahers' request to put the money in short-term, low-risk investments such as Treasurys and municipal bonds."
According to the Mahers, they didn't realize that Lehman was putting their money into these potentially volatile securities. As the fixed-income markets became increasingly unstable late last year, these securities fell victim to demand simply evaporating, necessitating very high rates of interest to result from the auctions. The Mahers had informal asset management advice from a banker, Mr. Liu, at the firm that sold their business, Greenhill & Co. So abstruse were the instruments that even Mr. Liu didn't fully understand them.
The article continues,
"Baffled by the codes, Mr. Liu says he phoned Lehman and learned that many were corporate auction-rate securities. Mr. Liu, who had only a vague understanding of the securities, asked Lehman for details.
Auction-rate securities usually are long-term bonds with interest rates that are reset periodically (usually once a month) at an auction. Because the auctions happen so often, the bonds traditionally were much easier to buy and sell than other forms of long-term debt. Auction-rate securities worked well for over 20 years and were regarded by Wall Street as cashlike investments, since they were highly liquid and highly rated.
But if buyers stop showing up for auctions, they become tough to sell, or even to value."
So we see yet another instance in which investors failed to completely understand that, for some instruments, there is no way a market can be guaranteed to exist continuously. In this case, rather than frequent auctions keeping yields competitive, but leaving the securities reasonably valuable, the lack of risk appetite by buyers has caused rates to skyrocket, correspondingly sending the bond values plummeting.
And, in a page right out of the CDO story, sometimes the bonds can't be valued at all, because the auctions draw no bidders.
Oops!
Regarding Lehman, the article continues,
"Mr. Liu says he came away from his conversation with Lehman unsure of the quality of the bonds' underlying assets. He consulted with the Mahers, and they agreed the bonds should be sold as soon as possible. Mr. Liu told Lehman to "unwind the positions and give the Mahers their money back."
Lehman, however, had trouble selling. In early August, the market for auction-rate securities grew skittish as one auction for lower-grade securities failed.Lehman had put the Mahers into most of their auction-rate securities a few weeks earlier, in July. It reinvested about $100 million of the Mahers' money in auction-rate securities in mid-August, the Mahers say."
So Lehman, according to the Maher's and their informal advisor, Mr. Liu, failed to invest the Maher's money as directed. Apparently, the Maher's aren't the only investors displeased with Lehman's conduct involving auction-rate securities. The Journal article concludes with the passage,
"Many companies, including 3M and US Airways, are already writing down the value of their auction-rate securities. Bristol-Myers Squibb in January took an impairment charge of $275 million because of auction-rate securities it held.
Merrill Lynch & Co. recently bought back $13.9 million in debt securities that it sold to the city of Springfield, Mass. The Massachusetts secretary of state has since filed a civil lawsuit against Merrill charging the firm with fraud and misrepresentation.
In their claim, the Mahers are demanding their $286 million back from Lehman, along with interest, and are seeking punitive damages of up to an additional $857 million."
Just when you thought you had understood some of the more exotic credit market instruments, this story appears. It turns out that the Port Authority of New York and New Jersey saw its interest rate on auction-rate securities it issued jump to 20% this week, amidst weak investor demand for the notes.
How is it that with so many educated, intelligent investment bankers working in fixed-income departments throughout the industry, instruments such as CDOs and auction-rate debt fail to observe that there are times when demand for such exotic securities evaporates? And current 'values' cannot be easily determined?
If well-compensated, experienced sellers and investors continue to trade these instruments, without realizing all of the risks, can any regulator or government really have an impact on this business?
Or do investors and issuers simply need to experience the pain of loss with these securities, in order to learn not to participate in those markets anymore?
9 comments:
This market is experiencing a temporary liquidity crisis. The Maher's haven't lost a dime in these instruments and won't as long as they wait for the market to resolve itself. Even if it doesn't there are 3 ways for a resolution. A secondary market will be created, the debt will be called at par, or refinancing the debt. All of these solutions would enable the Maher's at getting their investments back without incurring a loss.
anonymous
Thanks for your comment. I noted many visits from Lehman today, but I don't know if you are from that firm.
Technically, of course, you are correct in writing that the Maher's
won't (lose a dime) as long as they wait for the market to resolve itself.
Just like, say, owning RCA or other equities in 1929?
Given sufficient time, the market could, and probably will, come back to where these securities are at least at par value.
Will a secondary market be created? Why? In whose interest is it to create and trade such an illiquid market? More likely, some hedge fund or private equity trading desk will scoop up the depressed-value bonds.
Can the debt be called at par? If so, why do you suppose this wasn't mentioned in the article? Or this morning on CNBC, when the various co-anchors and guests chortled at how the buyers were at the mercy of the issuers?
Refinancing? Yes, that was mentioned, which is a sort of call.
But the overall point still stands. Buyers evidently don't realize that exotic fixed income securities like this, without committed, guaranteed specialists who make markets, for a fee, always carry a risk that the market for them will simply cease to exist for periods of time.
And in those periods, investors will want some valuation.
To that point, there's an interesting piece in today's Journal describing the various viewpoints about 'market value' pricing.
Still, the temporary liquidity crisis is a non-trivial risk, don't you think?
-CN
Comparing this situation the Great Depression is ridiculous. Municipalities are already calling away the debt, which will inevitably increase liquidity throughout the market. You can rest assured this market will cease to exist in upcoming months, with all investors getting their principal back unscathed. All investors that participated in the last 24 years recieved better than money market returns without ever risking their principal. It's a shame that over-emotional and unreasonable skeptics will cause this market to see an end.
anonymous-
Your continued comments seem to suggest a vested interest.
Of course a comparison to the Great Depression would be ridiculous. However, you're sloppy.
I alluded to the crash, not the depression.
My point, which you evidently missed, is that one never knows how much time will pass before the hoped-for return of liquidity and original valuations.
You say one can 'rest assured' investors will receive their principal back.
As I will write in an upcoming post, though, many were led to believe that there was a more continuous market at near-par values than there is.
If the market were truly serving investors, it would remain.
If not, or it's been mis-represented, abused and over-sold, it will not.
-CN
I apologize for my sloppyness. You are correct. Investors were led to believe that a near term market would exist beacause that has been the case the past 24 years. But my point is this. This liquidity risk is disclosed in every prospectus of every ARS sold through a major institution. There is now an incentive to purchase the remaining ARS because the remaining issuers are paying much higher penalty rates (over 10% tax free in some cases). After the remaining supply is sold, the issuers will take the lead of those municipalities that are calling the debt away (i.e. NY/NJ Port Authority). This will completely put an end to the market. The investor, though not having the liquidity they "were led to believe" will be receiving a significantly higher rate in upcoming weeks. Thus, the market is no longer serving the issuers, not the investors. There is now no incentive for an issuer to participate in an auction because this uneducated media banter will scare any future investor from participating.
Thanks again for your comment.
Your point is valid that now it is the issuers who are not well-served by this type of security.
Does it not strike you as telling, though, that both sellers and buyers found the securities, and the 'market-like' trading environments for them, to be behaving dysfunctionally?
If the buyers didn't find the ARS to possess features they thought were resident, and the issuers now find themselves replacing the notes with traditional long-term instruments, why did these securities exist?
Could it be they were simply fragile flowers of a temporary hot-house sort of market context?
-CN
It could be, but this market gave everyone involved what they wanted for a very long period of time. Essentially, all these instruments are just 30 year or perpetual debt that was in demand because of its functioning weekly or monthly liquidity to investors. So, as an investor you could purchase insured short-term debt with high yields relative to money market rates. As an issuer, the debt was in demand because of the perceived safety of the bond insurers. Because this debt is AAA rated, it enabled issuers with lower underlying credit quality to borrow with a AAA rating. Citi, UBS, Lehman, etc. all took their cut in the process. Everyone was happy. Now investors don't want to touch it, issuers won't be able to participate, and broker-dealers are caught in the middle dumbfounded. Noone thought that subprime fear would spill into this market, but recent credit concern amongst the insurers themselves is the main cause of this mess. I think we both can agree we are in interesting times.
c:
A google search took me to your post from February. What you and the commenters missed is that the ARS owned by the Mahers were not the run-of-the-mill muni or preferred ARS. What they owned was the toxic variety that was backed by CDOs, CLOs and monoline contingency liabilities. This crap, paying yields before the freeze of 50-150 bps over the overall ARS market, failed when the credit crunch first arose in late Summer 2007. This is the same crap that Bristol Myers, ADCT, Lawson Software and other corporations have written down to 20-50 cents (that's down to, not written down by).
Thus, the Maher issues had nothing to do with the broader ARS market failure that began in February. Commenter anonymouse 5:37 could not have been more wrong on this stuff.
anonymous (last)-
Thanks for your comment.
I'm not sure it matters all that much what exactly was the basis for the Maher's losses, in terms of which toxic aspect caused their losses- the ARS features, of the CDO and similar features.
They seemed to have been sold somehting under false pretenses, but, too, didn't really perform due diligence.
So many of these customers fell for the line, as did a WSJ columnist, about whom I wrote last week,
'we have this for our best customers......'
Yeah. Right.
-CN
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