The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).

As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.

The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.

As reported in a recent Barron's article, how much money investors get back from auction-rate securities depends on who originally issued the securities. Auction-rate securities are debt that matures in 30 year or more, sometimes in perpetuity. The recent increase in the number sellers compared to buyers has caused some problems in the market, with some issuers running for the door. How the security was initially issued, and for what purpose, may impact how fast you are able to redeem the security.

The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will also likely receive their money, but may have to wait a little longer. Not surprisingly, the investors that purchased auction-rate securities sold by a CDO or student-loan trust will not get their money back for some time, up to many years. Many auction-rate security holders have no idea what the CDOs own since the information is not disclosed. Estimates have about $20 billion of CDO auction-rate securities that are failing to be sold in auction and therefore illiquid. Many of these securities will not be redeemed, and will essentially stay outstanding until the CDO either collapses, or the investment within the CDO mature - in some cases, many years out.

For student loans, many loans are financed by selling them into a trust, and the trust then sells medium and long-term debt, some of which are auction-rate securities. For the trust, there are not many refinancing options given that student-loan financing costs have gone up quickly. Initial rates from some failed auctions were 10% or higher. To prevent problems, some trust have a mechanism that prevents the average rate from going high enough so as to push a trust into default. Some student-loan based auction-rate securities are therefore offering 0% rates to investors, with average rates of 3%. With such low rates, this doesn't encourage student-loan trusts to fix the liquidity problems anytime soon.

Unfortunately, auction-rate securities are probably just one example of what is no doubt becoming a much larger problem. As investment companies continue to deal with their own credit issues, expect more of the fixes, and consequences, to roll down hill.