In the News: Recent Developments

February 21 , 2008

Auction Debt Succumbs to Bid-Rig Taint as Citi Flees (Update4)

By Darrell Preston

Published in Bloomberg News / BusinessWire

Feb. 21 (Bloomberg)

The collapse of the auction-rate bond market, where state and local governments go to raise cash, demonstrates that regulators are no match for Wall Street.

Hundreds of auctions have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales. Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.

Inadequate disclosure “may have masked the impact of broker-dealer bidding on rates and liquidity,” Martha Haines, head of the Securities and Exchange Commission’s municipal office, said in an interview. “The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.”

Citizens Property Insurance of Tallahassee, Florida, a state-run insurer that protects homeowners against hurricane losses, is a casualty. The rate Citizens pays on a portion of the $4.75 billion in securities it has sold jumped to 15 percent from 5 percent at an auction run by UBS that failed on Feb. 13.

No ‘Backstop’

“The banks were the backstop,” said Sharon Binnun, the chief financial officer of Citizens. “If you had more sell orders than buy orders, they’d pick up the difference and you wouldn’t have a failed auction.”

Officials at Goldman, Citigroup, UBS and Merrill declined to comment. All the firms are based in New York, except UBS, which is in Zurich. UBS told its brokers this month that it won’t buy bonds that fail to attract enough bidders, and Merrill said it was reducing its purchases.

Auction-rate securities are long-term bonds whose interest resets every seven, 28 or 35 days at bidding run by a dealer who collects a fee of about 25 basis points. Unlike Treasuries or stocks, there is no daily source of information about auction- rate bonds. Issuers have relied on banks to be buyers of last resort when bidders couldn’t be found at their auctions.

Since the first of the securities were sold in 1984 for American Express Co., the market has expanded as investors sought the bonds as a higher-yielding alternative to money funds.

SEC Fines

Along the way, New York-based Lehman Brothers Holdings Inc. was fined $850,000 in 1995 by the SEC for manipulating auctions conducted for American Express. Almost two years ago, 15 securities firms paid the SEC $13 million to settle claims of bid-rigging in auction-rate bonds. The banks neither admitted nor denied wrongdoing.

While the SEC required dealers to disclose that they may use insider knowledge to place bids, they don’t have to say how frequently they bid or how much. Dealers also aren’t obligated to disclose rates on auction debt when the securities trade.

Current rules don’t go far enough because they still deprive investors of information they need to make informed bids, said Joseph Fichera, chief executive of Saber Partners LLC, an advisory firm in New York. The U.S. Treasury market’s system of bidding and disclosing bids should be a model for the auction- rate market, Fichera said.

“Investors aren’t sure they can sell the bonds when they want,” Fichera said.

‘Greatest Fear’

Rancho Palos Verdes, California, investor Frank Glaser, who put $125,000 of his family’s money into auction-rate securities at the recommendation of a broker at UBS, couldn’t get the money after auctions started failing this month.

“It’s my greatest fear that we’re going to sit with it forever,” said Glaser, 74, a former executive with Hughes Aircraft Co. “They were making a market and then they stopped. They need to start it back up.”

Aside from the SEC fines, the market worked smoothly until November, when investors began pulling back from all except the safest of government debt as losses on securities tied to subprime mortgages began infecting other parts of the credit market.

Liquidity Issue

Wall Street firms, reeling from $146 billion in losses on their debt holdings, became unwilling to commit their own capital to support auctions that don’t attract enough bidders.

“It’s more a liquidity issue, I don’t think there’s a concern here about these entities being able to repay their debts,” said Tony Crescenzi, chief bond-market strategist in New York at Miller Tabak & Co., in an interview today with Bloomberg. “These auction-rate securities are proving to no longer be viable, and we’ll see them diminish in scope and size as we go forward.”

A month ago, it was “unthinkable” that the banks wouldn’t intervene to support auctions, said Steven Brooks, executive director of the North Carolina State Education Assistance Agency. “I had certainly hoped and believed that that liquidity was there and was an important part of why this marketplace was good for investors and good for issuers.”

‘Ugly’ Market

From 1984 through 2006, only 13 auctions failed, typically because of changes in the credit of the borrower, according to Moody’s Investors Service. There were 31 failures in the second half of 2007, and 32 during a two-week period beginning in January. That compares with more than 480 failures yesterday alone, according to figures compiled by Deutsche Bank AG, Wilmington Trust Corp. and Bank of New York Mellon Corp.

“It’s ugly,” said Luis I. Alfaro-Martinez, finance director for the Government Development Bank of Puerto Rico, which saw the rate it pays on $62 million of debt rise to the maximum of 12 percent set out in documents governing the bonds, from 4 percent at a Feb. 12 auction handled by Goldman. “It’s getting uglier.”

The average rate for seven-day municipal auction bonds rose to a record 6.59 percent on Feb. 13 from 4.03 percent the previous week, according to indexes compiled by the Securities Industry and Financial Markets Association.

The higher rates drove California, the biggest borrower in the municipal bond market, to decide to replace $1.25 billion of auction-rate bonds with traditional debt.

Lacking ‘Confidence’

“We don’t have a lot of confidence in this market,” said state debt manager Paul Rosentiel. “It’s going to be very hard for this market to recover.”

State regulators are scrutinizing sales of auction-rate securities by closed-end mutual funds after investors complained they couldn’t sell their holdings. Massachusetts Secretary of State William Galvin asked nine fund companies for information on failed auctions, his office said in a statement.

Ohio Attorney General Marc Dann may file lawsuits after state funds bought the securities, said spokeswoman Jennifer Brindisi said.

Citizens in Florida plans to convert auction-rate debt to variable-rate notes or fixed-rate bonds, Binnun said. The company bought back $800 million of its auction-rate debt, she said.

The Internal Revenue Service said this week that it plans to issue new rules that would make it easier for local governments to convert high-rate auction bonds to lower-cost debt. The changes wouldn’t be such a significant modification that it would amount to a re-issuance of the bonds, the agency said.


“There’s never been anything like this,” said Kevin Shanley, chief financial officer of Summit, New Jersey-based AHS Hospital Corp., which owns two hospitals in northern New Jersey. AHS saw the rate it pays on $60 million of securities rise to 12 percent from 3 percent at auctions last week. “I won’t pay 12 percent for more than one minute without refinancing.”

The rate on $100 million of auction debt sold by Wisconsin to its pension plan jumped to a record 11.5 percent on Feb. 14. Now, the state is considering options that include converting the bonds to other types of debt.

“My pulse is racing,” said Frank Hoadley, director of capital finance for Wisconsin. The rate “is obviously very expensive and unacceptable,” he said.

Regulators are calling for more disclosure in the wake of the failures. The Municipal Securities Rulemaking Board, which makes rules for dealers in the municipal bond market, is considering rules that would force dealers to reveal the number of bidders and disclose how often auctions fail, Executive Director Lynnette Hotchkiss said in a Feb. 14 interview.

For some borrowers, that may not be enough.

“It’s not attractive,” said Renee Wasmund, finance director of the San Diego Regional Transportation Commission, which pulled a $300 million sale this month. “We’re not doing any auction-rate securities.”

—To contact the reporter on this story: Darrell Preston in Dallas at

—Last updated: February 21, 2008 18:16 EST

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