Auction-rate securities

Citi Slickers

Fancy products cooked up by over-achieving bankers often have unintended consequences. That is because they are designed assuming rational behavior, whereas markets have a nasty tendency to react unpredictably. Take auction-rate securities (ARS), debt instruments or preferred stock that reset through regular auctions. These instruments were widely sold as a way to push up returns without sacrificing much liquidity. Many investors say they were led to believe that they could easily get out because Wall Street would support the auctions in case of a crisis. But when push came to shove in February, the big underwriters stepped back and the $330 billion market collapsed.

Now Citigroup, the largest seller of ARS, has agreed to buy back at par $7.5 billion worth of these frozen instruments from 38,000 retail investors and pay damages to those who have already sold at a loss. The bank has also committed to try to liquidate $12 billion in frozen securities that were sold to institutional investors by the end of 2009. Citigroup will also pay $100 million in penalties to New York and other state securities regulators. The Securities and Exchange Commission is withholding judgment whether to add a federal penalty until the process is complete.

The deal lays down a marker that other underwriters may have to follow. Merrill Lynch will likely face pressure to make investors whole, and UBS, where one of the executives has been accused of insider trading, could face tougher penalties. Industry regulators are also probing other brokers to see if they misled investors about safety and suitability.

It is right to be alarmed by the problems in ARS where long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. The allure for issuers, including hundreds of municipal bodies, is lower interest rates than typical long-term bonds, and the ease of paying down debt if they build up a surplus, by simply taking part in the auction themselves.

But lately dozens of auctions have failed as investors have questioned the quality of the assets on offer. Tens of billions of dollars of bonds have gone unsold, which has come as a shock to corporate treasurers who piled into auction-rate debt assuming it to be safe. Because the interest rate automatically clicks up if the auction is a dud, hospitals, museums, universities and ports have suddenly found their debt-service bills rising sharply. Issuers have scrambled to refinance into proper long-term bonds, or asked banks for letters of credit. The Treasury has even offered to make it easier for issuers to convert to other types of debt. 

The inquiry by regulators is moving much faster than some of the other investigations arising from the credit crunch and the total cost of resolving it could easily dwarf the research analyst settlement that resulted from dubious practices during the technology bubble. That reflects the high priority U.S. regulators place on protecting ordinary people in a country where half of all households own stock. The message from the settlement with Citigroup is clear: when Wall Street shenanigans start hurting main street pocketbooks, the chickens will come home to roost.