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 discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

There has been a recent resurgence in interest in dark pools of liquidity. No, this is not some Star Wars reference (at least I don't think so), but does refer to a procedure and method of trading that is once again causing some concern on Wall Street. For years, crossing networks have been matching buy and sell orders "off-exchange" in what have been referred to as dark pools of liquidity. The advantage of these pools it that they should make the execution of a large order safe, and allow the two market participants to execute the large order without moving price, while maintaining some privacy. While the amount of dark pool transactions is estimated to be a little over 10% (but including more than 20% of all trades in NYSE-listed stocks), it is continuing to grow as hedge funds look for less transparent ways to sell large positions, and brokerage firms look for more ways to generate trading income and possibly tap into the increase in trading revenue streams that the exchanges have been enjoying over the last few years.

Unfortunately, some are worried that gaming is allowing others to profit from the transaction, and of course potentially leaving one side of the dark pool transaction a little worse off. The problem has gotten significant enough that some are considering no longer using the dark pools, with 60% showing some hesitation. As recently highlighted in a Finanial News article, steps are being taken to tackle the problem, such as putting anti-gaming measures in place at both large and small firms. Steps being used and/or considered include physically monitoring patterns of trade abuse using a human element, using computer algorithms to spot trends, developing fair pricing models, and using anti-gaming logic.

While it is true that it may not always be known exactly what is occurring within the dark pools, it appears as if their operations are simply more organized ways to perform crossing of block trades, with a print of the tape after the transaction is complete. Nonetheless, it is still surprising to me how in the current financial environment that the SEC, other regulators, and some of the exchanges themselves have not spoken more about dark pools, their transparency (or lack of transparency), and the affect this has on price discovery. In fact, it seems to me that given current credit issues, this might not be a something the industry wants to advertise. Yet, this is apparently not stopping some.

As recently reported at the Deal Breaker blog, Goldman Sachs, Morgan Stanley and UBS have agreed to share their dark pools, such that each will allow for the secretive trading to take place between their clients. The dark pools include Goldman Sach's Sigma X, Morgan Stanley's MS POOL, and UBS's PIN ATS. The union further threatens to take business from the exchanges and furthers current consolidation of the brokerage industry. Right now exchanges are at a disadvantage when they try to compete with the dark pools since they are being regulated by the SEC, with new rules being put in place over the last year forcing them to share even more information and route trades to the exchange offering the best price and fastest execution. Dark pools have in many instances been able to avoid regulation by keeping trading volumes under a set threshold.

But again, while this is probably a good move for the financial institutions with regard to generating new business, lowering costs, and helping to tap into the monopolies of the exchanges, it is probably not the most public relations friendly move in the current credit environment. As is often unfortunately the case, this will surely cause some in Congress to start talking of new regulation, especially if someone goes way out on a limb and attempts to tie the practice to home foreclosures or high energy cost - adding a new level of regulation with the usual unintended consequences. If this happens, we may end up wishing that a dark pool of liquidity was truly just a Star War reference.

Shares of UBS were up in Switzerland. The move is being attributed to investor relief over the Chairman's (Marcel Ospel) departure. The company is also asking shareholders to approve approximately $15.07 billion US dollars in additional funds to support its shrinking capital base. S&P cut its rating on UBS from AA to AA-.

Apparently, the Q1 loss is driven by $19 billion in write-downs in illiquid real-estate assets. This brings their total to around $33 billion in total write-downs. Of interest is how UBS plans to place these losses in a separate unit, initially funding the unit, while exploring the option of a spin-off or outright sell.

US futures are rising this morning (up close to 1%), apparently on the belief that the recent write-downs from Deutsche Bank at $3.9 billion (and UBS today) would be the last of the major credit-related problems.

Update: Of interest was a report that the Swiss Exchange is not allowing short sales of UBS today. The move today - a 10% pop instead of an expected 10% drop. Probably not the entire reason for the move, but I am sure it didn't hurt.

Ticker: UBS