Thursday, February 28, 2008

Auction Rate Securities: Manipulated from the get-go

(Naked Capitalism) DealBreaker does some serious reporting today, informing us that some traders have told them that the failed auction rate securities market was always dependent on stabilization by dealers.

For anyone who has worked in the securities industry, the term "stabilization" pregnant with regulatory significance. Stabilization, as defined by the SEC, is
…transactions for the purpose of preventing or retarding a decline in the market price of a security to facilitate an offering....Although stabilization is a price-influencing activity intended to induce others to purchase the offered security, when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers.

So let's be clear about this: stabilization is a form of market manipulation authorized by the SEC. Its main use is in public offerings of stocks. Immediately after the shares are issued, the syndicate manager will intervene in the trading, usually for the first day, to make sure (if possible) that the shares don't fall unduly.

So the question with the ABS market is: did the market manipulation by the dealers fall within SEC guidelines? DealBreaker has doubts:
The immediate cause of the auction failures was the pullback of the banks and brokerages. In mid-February the financial institutions conducting the auctions stopped acting as principals or buyers of excess ARS inventory....

“Wall Street executives have defended their conduct, saying losses on holdings such as mortgage assets have curtailed their ability to use their balance sheets to support faltering markets,” the Wall Street Journal’s Randall Smith and Liz Rappaport report in their article today about a large bond marketer lashing out against Wall Street over the auction failures.

But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.

“The truth is there was no natural auction success rate. But for the banks acting as market makers, these auctions would have failed from the get go,” a bond trader told DealBreaker.

Rather than merely acting as buyers of the last resort, the financial institutions have been consistently called upon to stabilize the ARS market. In many cases, investors were lead to believe the market was much healthier than it has ever been. But with balance sheet capital at a premium due to recent losses, the banks decided that the fees received for structuring the auctions and managing clients money in ARS were did not justify deploying the capital necessary to support the market.

If these bond traders are correct about the way the ARS market operated, Wall Street may soon find itself the subject of yet another round of lawsuits and investigations by authorities.

And indeed, in 2006, the SEC's chief of the Office of Municipal Securities, Martha Mahan Haines made remarks that now seem prescient, particularly where she suggests ABS should be called "BS Securities".

Her discussion refers to a settlement reached with 15 broker dealers regarding alleged manipulation in the ARS market in 2005:
If you read between the lines of the Commission’s recent settlements involving auction rate securities and the “Best Practices” released by TBMA, it appears that the way rates are actually set on auction rate securities often may bear little resemblance to the way the process was described in offering statements...... The market for ARS bears little resemblance to the kind of so-called Dutch auctions known to most investors: those for U.S. Treasury securities.....

As a result, I believe that a few topics about the auction rate market generally avoided before now, should be aired and discussed. First of all, we should acknowledge that, although broker-dealers involved in this market generally claim that their intervention is for the good of the market as a whole, this has not been studied. In fact, the outcome of even a completely independent study would be dependent on one’s view of what is best for the market. It is true that, due in large part to BD intervention, there have been few “failed” auctions, resulting in windfall interest rates for investors until the next auction, or “all hold” auctions, resulting in below market rates briefly benefiting issuers. Broker-dealers also intervened when the rate that would be set was not, in that broker-dealer’s opinion, an appropriate market rate. (But wasn’t a determination of the market rate the very purpose of an auction?) We are told that this is in the best interests of both issuers and investors. But is it? ..... This intervention supported the rapid growth of this market to over $200 billion. Was it in the best interests of issuers and investors to be so heavily dependent on broker-dealer intervention to support the expansion of that market?....

Disclosure should make it clear that broker-dealers commonly intervene in auctions, bid with knowledge of other bids, submit bids after the internal bidding deadline imposed on other investors, and directly or indirectly influence or set the clearing rate with considerable frequency. I am not saying that this is necessarily good or bad, but it should be disclosed in plain language. ......Do not dance around this issue: describe what really happens flat out. If this is the way that investors and issuers prefer for the market to function, so be it. If not, perhaps practices should change to reflect their true preferences?

Secondly, it may not be accurate to call this an auction at all. In a true Dutch auction, no bidder has knowledge of the bids submitted by others. This protects the process from manipulation and ensures that the price set is truly reflective of the market. Perhaps consideration should be given to a different name for this type of security or of the process by which rates are set? “Managed auction process” and “bidding system” have been suggested to me..... I recognize that “BS Securities” is not an appealing acronym and I leave it to those more creative than me to come up with an alternative title....

Lastly, I would like to remind everyone that adherence to industry practices does not give anyone a pass under the securities laws. Although best practices and similar releases by industry organizations may be useful, it is important to keep the overarching requirements of the securities laws and its basic themes of disclosure, fairness and integrity firmly in mind.

The kind of disclosure Haines called for appears to have been neglected. For instance, in the widely reported case of the New Jersey Maher brothers, Lehman was given $600 million to manage and was told to put it temporarily in short-term liquid instruments while the brothers decided on their long-term strategy, $286 million went into auction rate securities and so far, the Mahers have been unable to access their cash. It's a virtual certainty that they were not told how the auction process worked. And if very large customers are ill informed, there is no reason to think the small fry are treated any better.

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