In the News: Recent Developments

July 16, 2004

California Plans Auction-Rate Bond Sale With SEC Probe Looming

By William Selway and Michael B. Marois

California plans to sell $250 million of auction-rate debt while the U.S. Securities and Exchange Commission investigates how securities firms set yields in the $204 billion market.

California will sell auction-rate debt even with a federal probe because the securities will cost less now than an alternative, variable-rate demand bonds, said Director of Public Finance Juan Fernandez. The state can easily switch out of auction-rate debt if yields start to rise, Fernandez said.

“We are watching the situation closely,” said Fernandez in an interview in his Sacramento office. “We have the flexibility to switch from auction rates if we see things not working out. But right now, auction rate is the most attractive alternative.”

The SEC is questioning whether brokers misled investors and issuers by allowing some bidders special treatment, which may boost costs to sellers or reduce returns to investors. Auction-rate bond brokers were asked to provide reports detailing “potentially deceptive, dishonest or unfair practices,” according to a memo trade associations sent to members.

A decision to cancel auction-rate bond sales may reduce municipal underwriting revenue for securities firms such as Citigroup Inc. and UBS AG, the two largest managers of such sales. Underwriters charge 0.25 percent of the bonds’ face amount annually as a fee to run the auction, or five times the fees on the 0.05 percentage point charged for variable-rate bonds with interest rates tied to an index, according to Joseph Fichera, chief executive of Saber Partners LLC of New York.

Big Business

“This is a big banking business for them,” said John Flahive, director of fixed income for Mellon Private Wealth Management who manages $11 billion in municipal bonds in Boston.

A spokesman for UBS, Mark Arena, and Christina Pretto, a Citigroup spokeswoman, declined to comment.

The federal inquiry into the $204 billion market may be prompted by complaints of fund managers who say bidding is undermined by the investment banks that run the sales, some investors said.

“For too long, it’s been a black box for the investor,” Gary Pollack, a New York-based money manager who oversees $5 billion in municipal bonds, including $100 million in auction-rate bonds, for Deutsche Bank AG. “Sometimes we get shut out and we don’t understand why.”

Auction-rate bonds pay interest determined by Dutch auctions, in which the lowest yield becomes that at which the entire issue is sold. If auctioneers, who know all the bids, coach favored bidders or submit bids themselves, investor returns may be reduced or borrowing costs may rise for issuers.

`Proprietary Interest’

“You’re giving your bid to a guy who has a proprietary interest,” said George Calvert Jr., who manages $400 million in municipal bonds for Trusco Capital Management in Richmond, Virginia. “That’s where I think the inquiry is coming from: People in that market are wondering how it gets done.”

The Illinois Student Assistance Commission, with $2.5 billion in auction-rate debt outstanding, is reconsidering whether to sell those securities, said Tom Sakos, whose Deerfield, Illinois, commission ranks sixth in auction-rate bonds issued.

“We may consider that option a little more strongly, depending on what comes out in the next few weeks” with the investigation, said Sakos.

Cook County, Illinois, scrapped a $200 million sale after the SEC probe was disclosed three weeks ago. A.G. Edwards Inc., a St. Louis-based brokerage, on Monday said it suspended one employee in connection with the SEC probe and was conducting an internal review of its auction-rate bond operation.

Low Yields

Issuers have been drawn to auction-rate debt because it allows them to pay yields as low as 1 percent now while borrowing the principal for more than 20 years. An auction-rate bond maturing in 31 years sold by the Illinois Student Assistance Commission pays interest at a rate of 1.4 percent, according to Bloomberg Data. By comparison, 10-year U.S. government bonds, the least-risky benchmark for U.S. fixed income, yesterday yielded 4.48 percent.

The California bonds will be sold in August by the California Infrastructure and Economic Development Bank through a group led by UBS AG, the second-largest underwriter of auction-rate bonds according to Thomson Financial. The state will sell $500 million of fixed-rate workers compensation bonds July 26, also led by UBS.

–Editors: Pittman

To contact the reporter on this story:
William Selway in San Francisco at (1)(415) 743-3511 or at

To contact the editor responsible for this story:
Mark Pittman at (1)(212) 893-3767 or at

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