Every now and then an obscure instrument from the world of finance pops up to claim its short period of fame, even if for the wrong reasons. The most recent is a set of instruments with the crude but confounding name “auction rate securities”. In normal times the ordinary citizen can ignore these obscure financial instruments. But these are not normal times. As a result these oddly-named securities have come to be one more symbol of all that is wrong with global financial markets.

Let us begin at the beginning. One lesson from the sub-prime crisis that has afflicted the international financial system since the middle of last year is that there is so little that both ordinary retail investors and the regulators know about what goes on in the murky world of international finance. Markets and institutions that were till last recently presented as being transparent, competitive and efficient have proved to be opaque, interlocked, collusive and prone to failure. It is now accepted by even the most vocal “market fundamentalists” that intervention by the state, in the form of liquidity injections, debt restructuring support and even nationalization, is unavoidable if the crisis is to be prevented from turning the economic clock back a decade or more. Financial markets just cannot be left alone.

What is shocking, however, is that even when these truths are being rediscovered, the tendency for large financial institutions to misinform and mislead in order to garner gains at the expense of retail investors has only persisted. In fact, as the losses incurred by these institutions increase, they are, it appears, seeking illegitimate ways to pass on these losses to the retail market in order to shore up their own balance sheets. And the instruments they use are, as before, the ostensibly innovative financial products which modern finance is able to create to deliver better returns for its creators.

The most recent evidence of such practices comes from the scandal in the “innovatively”-named auction rate securities (ARS) market. Auction rate securities are long-term debt instruments that borrowers like corporations, municipalities or even student loan agencies issue, encouraged by their financial advisors. The interest on these securities are variable over time and are determined in periodic auctions where these securities are bought and sold at par value to bidders who accept the lowest interest. The auctions are often of the type where the auctioneer starts with an asking rate and continuously increases it till a bidder is (or bidders are) found. The advantage of this form of “Dutch” auction is that a single or a few bidders are adequate to complete the sale, increasing the liquidity of the asset.

On the surface, this seems a perfectly efficient use of market principles in the interaction between borrowers and lenders. The interest rate is determined through a transparent auction. The asset appears liquid, even if not as liquid as cash or deposits, since it is periodically being bought and sold. And being debt, often issued by respectable economic entities, it appears safe as well.

The difficulty is that the value of these securities is dependent on presence of an active market in which they can be periodically auctioned and the interest rate reset. In a situation such as we have now where liquidity has dried up, there are few or no buyers in various segments of the ARS market. This implies that these assets which were considered close to bank deposits in terms of liquidity, since they could be auctioned, are now illiquid. This freezing of the market reduces substantially the notional value of the securities involved. Since many banks hold securities of these kinds, if they follow the principal of valuing these securities on a mark-to-market basis, they would suffer a substantial erosion of their capital base. This had, allegedly, encouraged many leading international and Wall Street banks to sell these securities to inadequately informed and unsuspecting investors, when the signs were that a credit squeeze had begun.

Auction rate securities are creations of the late 1980s, the era of liberalization and innovation in the US financial market. The New York Times reported in its March 17, 1988 edition that “Dutch auction securities, often used by many corporate preferred stock financings, have been introduced for the first time to the tax-exempt market by Goldman, Sachs & Company through a new instrument called ''periodic auction reset securities.''” Since then the size of the market has grown and is currently estimated at $330 billion, 53 per cent of which is backed by student loan and other tax exempt collateral.

The problem is that starting early this year, this market too became victim of the credit squeeze triggered by the sub-prime crisis, since its viability is based on a vibrant auction market. As credit became scarce and the fear of default increased, buyers were hard to find. Soon news emerged that many retail investors who were convinced by banks that these investments were similar to cash deposits or liquid money market accounts, had now found that their savings which they wanted to access at short notice were frozen. There were few buyers and banks and other dealers who promoted and supported these securities refused to lift unsold securities in auctions they managed.

Prompted by stories of harried retail investors, the New York attorney-general, Andrew Cuomo, the Securities and Exchange Commission, and 12 state securities regulators began investigating these cases and finding evidence which suggested that the banks had been recommending these investments even when they knew that the market was collapsing for lack of liquidity. The problem they argued was a creation of the banks, and they had to both correct it as well as pay a penalty for their bad practices.
To their credit, they threatened prosecution if the institutions concerned did not come in and buy these securities at par to revive the market. Initially the firms resisted. The reason was clear. With these securities having turned illiquid and their notional prices having fallen sharply, banks would have to accept large write-offs and losses on their already weak balance sheets, eroding their capital base and worsening their financial position.

But with regulators deciding to turn the screws and make auction rate securities the next example of evidence of financial malpractices that fuelled the credit spiral that is now unwinding, the banks are falling in line. They are choosing to settle by offering a staggered buyback of large volumes of securities from investors as well as agreeing to pay penalties of different sizes without denying or admitting any malpractice. By the middle of August the total buyback agreed to in settlements by UBS, Merrill Lynch, Citgroup, JP Morgan, Morgan Stanley and others totaled $48 billion.

Besides saving their reputations and evading prosecution, banks may be choosing the buy back route because they do have some freedom in valuing these securities when they are posted on their balance sheets. As Aline van Duyn argued in The Financial Times (2 August 2008): “The sector offers a real-life laboratory to test the theories about fair-value accounting. The boom in structured finance has created hundreds if not thousands of pages of rules and guidelines on how to value them. One of the most fascinating lessons to emerge from that is that accountants can sign off on any number of values for the same security at different clients. As long as there is a rational argument behind the valuation, it is acceptable.” Banks could possibly find arguments to justify valuations that show them to be financially strong, when they are actually not.

While the banks may be suffering losses today, their ability to finance these losses with past profits, to escape prosecution and to dress up their balance sheets means that they are unlikely to abjure practices of this kind in the future. The system would continue to court risk and transfer losses to unsuspecting investors. Unless a crisis of large proportions forces a fundamental rethink of what kinds of markets, instruments and practices are acceptable and what kind of regulation is needed to rein in big finance.

September 05 , 2008.