Auction-Rate Securities Troubles & Liquidity

Last week I wrote this post based upon the Wall Street Journal article describing how two Lehman customers lost considerable value in their holdings which had been invested in auction-rate securities.


An anonymous reader commented,


"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."


To which I replied,


"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?"


Last Thursday's Wall Street Journal continued the theme, citing other brokerage customers who are being allowed to use their 'frozen' auction-rate assets as collateral for loans from their brokers.


Liquidity, indeed, is the point here.


According to the later Journal article, quite a few customers at various brokerage firms have been sold ARSs as 'cash equivalents.'


Surprise!


The anonymous commentator on my earlier post continued to bemoan the public's misunderstanding of, and lack of patience with ARSs, finally noting that now, with the spike in weekly reset rates, the instruments are no longer attractive to issuers.


To which I would respond, here, that (obviously) securities markets exist for those instruments which satisfy the needs of both borrowers and lenders, or sellers and buyers. When the normal behavior of a security is in a range outside which the expected behavior of the security by those who designed it, somebody typically loses interest (no pun intended)- either issuer or holder.


For ARSs, the lack of demand at recent auctions have caused what were thought to be occasional emergency measures to become ordinary. The truth is, in an environment that suddenly views most non-vanilla fixed income instruments as suspect and unacceptably risky, the market for these exotics has simply vanished.


Customers are being allowed to use the now-illiquid notes as collateral for loans, while issuers are hustling to call the notes in favor of issuing plain long term bonds.


As a final note, a contact of mine related being in a meeting of a brokerage firm's registered reps, in which it became apparent that many of them had no idea how the ARSs actually work. This is so typical of Wall Street retail brokerage. Brokers sell instruments they don't understand to customers who trust them and, thus, have no understanding of how the assets actually function in various market conditions, or what risks they bear.


When exotic fixed income instruments for which markets can simply vanish are sold as near-cash equivalents, nobody is well-served, and there's going to be pain all around.