In the News: Recent Developments

June 30, 2004

SEC Inquiry May Disrupt Auction Securities Market: Joe Mysak

By Joe Mysak

(Commentary. Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)

Issuers should prepare for the worst, and get ready to redeem their auction rate securities.

That’s because they can expect more auctions to fail, as a result of the U.S. Securities and Exchange Commission’s inquiry into the market, reported last week.

When auctions fail, issuers must pay a penalty rate to compensate investors. Most issuers redeem their securities rather than pay the rate, which can be in the double digits.

More auctions may fail because the SEC doesn’t want Wall Street to share information in advance of auctions anymore. The SEC wants the process to be pure.

The SEC investigation seems to be all about sharing information. Three trade groups outlined the SEC’s inquiry in a memo to their members. The memo says the SEC sent letters to some brokers asking them to conduct internal investigations of their activities in the auction rate bond market and to send the agency a report “detailing any potentially deceptive, dishonest, or unfair market practices” they find.

That’s just a teensy bit disingenuous. The SEC says it knows there are practices that are deceptive, dishonest and unfair, and that “if a firm does not uncover particular abuses the staff has reason to believe might exist, they will ask follow-up questions,” according to the trade-group memo.

`Useless Information’

“The staff members who sent the letters to firms seemed surprised when we suggested the process could carry the risk that the staff might criticize firms that did not report back particular abuses that the staff knew existed because of evidence the staff had gathered,” the memo says.

The memo says the SEC request seemed “novel” to the trade group people. Ordinarily, the SEC comes calling with “document requests, testimony subpoenas and interrogatories.”

The SEC told the trade groups that it thought this approach would be more efficient and less burdensome. The SEC is afraid Wall Street will inundate it with “too much useless information,” the memo says. “They wanted to get answers quickly,” the memo adds.

The auction rate securities market totals more than $200 billion. At the end of 2003, municipal debt accounted for about $70 billion of that amount, according to Thomson Financial data. Last year, municipal issuers sold almost $45 billion in auction rate securities.

Issuer Savings

That growth is unlikely to continue, with the SEC inquiry. The market may, just may, dry up altogether. One issuer, Cook County, Illinois, has already canceled plans to sell auction rate securities.

What made the auction market so popular in the first place? For one thing, issuers get to borrow long-term, at extremely low rates, which are reset every seven to 35 days.

The real attraction, however, is that the holders of the securities don’t have the right to sell them back to the issuer, as is true with traditional variable-rate debt. That means the issuer doesn’t have to pay for a letter of credit.

Bankers make more putting together auction rate securities than variable-rate financings.

`Blind’ Auction

The trade group memo doesn’t say exactly which practices the SEC finds deceptive, dishonest, or unfair. The most likely target is the process itself. The rates are supposed to be set by auction. Before the auction, Wall Street talks about it.

“There rarely are true auctions,” is how Joseph Fichera, chief executive of Saber Partners LLC of New York and one of the pioneers in this market, put it. “There’s too much risk to both the investor and issuer for it to be a blind auction on such a frequent schedule. The broker may be eliminating the blindness to manage risk.”

In other words, says Fichera, to keep everything running smoothly, Wall Street talks about prices, and about how much in outstanding securities are up for sale, to ensure that there won’t be any disruptions like failed auctions.

Auctions are only supposed to fail when the issuer has experienced some sort of calamitous event to its credit, and sellers of the securities outnumber buyers.

Triple-A rated issuers don’t expect failures. Wall Street aims to please. That’s harder to do if you don’t share information.

The SEC isn’t interested in smooth operations. The SEC is interested in keeping the process pure and honest. It will be interesting to see if the auction rate securities market can run smoothly if its participants can’t share information about it.

–Editors: Ahearn, Todd.

To contact the writer of this column:
Joe Mysak in New York (1) (212) 318-2323 or

To contact the editor responsible for this column:
Bill Ahearn at (1) (212) 893-4197 or

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