ARC and ARP Securities: How Wall Street Brokerage Firms May Have Defrauded Their Clients Out of Billions Overnight
(Author’s name withheld by request)
[This expose is an exclusive publication by agreement of the law firm of Shepherd Smith Edwards & Kantas LTD LLP, however, the information and opinions stated therein are not necessarily those of the law firm or its partners.]
In the week of February 11, 2008 the 330 billion dollar “Auction Rate Securities” market seemed to collapse overnight. Suddenly some investors realized that they could not get out of their investments. Other issuers like the Port Authority of NY had to pay 20% to find takers. There was mass confusion of grand proportions. Even AAA credit not associated with the Bond insurers did not find takers.
What happened? No one seemed to truly know. Almost all articles blamed the ongoing liquidity crises. The question remained why on that faithful week did the “Auction Rate Securities” market collapse as opposed to other markets? What was unique to it?
Why so much mass confusion? It appears this ARS debacle is one of the most convoluted structures ever devised by Wall Street. The liquidity crises in this market was simply a symptom not the cause. Even more what happened on that faithful week was exposed by the liquidity crisis it was not caused by it.
Everyone has a piece of the puzzle but no one to date put it together in one document. The following is a compilation of information gathered from every source available. There are differences between issues of “Auction Rate Securities”. Hence, assumptions had to be made in piecing it together. Some inaccuracies may exist from the process of compiling such a complex puzzle.
However there was a great need to provide an architecture blueprint for law enforcement, regulatory agencies, law firms, journalists and investors alike from which they can proceed to further investigate.
TIME VALUE OF MONEY CONCEPT
One risk factor that determines interest rate is time risk. That is why a 50 year maturing security may offer a 10% interest rate while a short term 30 day note from the same company may pay just 6%. Conversely a security value is a function of the market interest rate of return. That is if you issued the same long term security referred to above for 6% (as opposed to the 10% market rate) the securities fair market value would be a little more than 60 cents on the dollar because that is what would be required to provide the investor a market rate of return of 10%.
Some securities also have call provision allowing the issuer to call back and pay off the security prior to the maturity date.
INTRODUCTION OF THE ARS MARKET
It started as a creative and market based structured product. It seems “Auction Rate Securities” got corrupted by greed, disregard of market principles, deceit, non disclosure, self dealing and material omission of fact which ended in the one of largest massive alleged frauds ever committed by Wall Street houses on their clients?
AUCTION RATE SECURITIES CERTIFICATES (“ARCS”)
Municipalities commonly issued long term bonds to finance their projects. Their projects tend to be capital intensive with long lives. They need to match the term payments on the bonds to their ability to pay from their incoming tax revenues.
Getting Municipal business is very competitive as many firms were clamoring for it. Investment bankers always looking for a competitive edge came up with a structured product called “Auction Rate Securities”. It allowed the municipality to issue long term securities thereby matching their revenue stream but at a reduced cost. The product was referred to as an ARC. (Eventually other non-municipal entities, mostly education or school loan related, started to issue ARCS.)
To reduce costs the security had to reduce time risk. This was accomplished by having the Municipality vary the interest rate periodically to market demands (every “reset date”, usually every 7 or 28 days) to ensure the investor will be able to sell his security and be made whole.
If the investor was not able to sell the security it required the Municipalities to pay a real interest rate penalty (“Penalty Rate”) some as high as 10%+ to compensate the investor for now having in effect an illiquid long term security (and hence additional time risk). At the same time this clause provides incentive for the issuer to make the investor whole as soon as possible and call the issue back cashing out the investor.
Using this structure provided the investor with an instrument that acted like a short term note. It allowed him to cash out every 7 or 28 days. It also reduced the cost of borrowing to the Municipality from what would have been a higher long term bond rate closer to what a lower short term note rate paid.
AUCTION RATE PREFERRED SECURITIES (“ARPS”)
As “Auction Rate Securities” proliferated through the market place any short term competitive edge the original investment bankers had evaporated. It was not easy to write this business. One had to find a real municipality that had a real project which needed funding. They did not come around every day. They could not simply be manufactured?
What if in a sense this structure could be manufactured elsewhere? It could be underwritten as fast as the manufacturing process would allow. Meet the closed end funds. There are many types and flavors to this family of funds. The ones we are referring to are those that issued preferred shares and structured and marketed them as so called “Auction Rate Securities”. Each fund, for example the NY Municipal Bond Fund, would issue its own preferred shares to raise capital for that particular fund.
Many of these closed end funds are simply entities that house long term financial assets which earn long term rates. Usually to fund the initial capital these structures would issue common shares. However in order to attract common shareholders and to provide a higher return than these shareholders could otherwise obtain on their own by holding the same underlying financial assets, a way was needed to boost said returns. Coincidently at the same time Wall Street was also seeking ways to proliferate their new found structure Auction Rate Securities. Hence a marriage was created by these closed end funds and the large brokerage houses. The closed end funds produced a product that was called preferred shares and was structured and marketed as “Auction Rate Securities” by the large houses to their client base. The product was referred to as ARPS.
ARPS ARE NOT MARKET BASED
The closed end funds issuing ARPS were basically warehouses for long term financial assets earning long term rates. They in no way wanted to payout anything near long term market rates for the ARPS. That would defeat their purpose of issuing them. The purpose of issuing ARPS was to make additional income between what they can earn on their long term assets and what they can have the brokerage houses get their clients to accept. Regardless of the fact that if these securities failed in auction, the investor would be left with a 50 year illiquid security they would pay nothing near the market rate for a traditional “preferred” security. In such a case this structure did not provide much of a financial incentive for the issuer to make the investor whole.
In fact, recently many ARPS in failed auctions paid as little as 4.3% to 4.7%. In effect this is actually a 50+/- year illiquid security whose market interest rate would need to be closer to 7% to 9%. A simple discount of future cash flow analysis means that this security is approximately only worth 60 cents on the dollar? As you can see this security could not stand on its own. It has no basis in market reality.
DECEPTION & NON-DISCLOSURE?
Wall Street and the closed end funds were happy to piggy back on the good reputation and name of the original structure and refer to ARPS as “Auction Rate Securities”. The fact is that ARPS referred to as Auction Rate anything is deceiving to the core. In many cases the auction so limited the amount the issuer would be willing to vary the rate to meet market demand, that it would have been more appropriately referred to as the “Dictated Interest Rate”. Also, if the auction failed the ARPS should have had a so called Penalty Rate. However, the ARPS penalty rate was capped so low that it had no market basis. It was a joke. There is and was no real penalty. It just made sense to resemble as close as possible in structure to the ARCS, such that most would not notice a difference and it could be marketed through the same brokers as nearly identical products.
After all the brokerage firm made billions from parts or all of this process by underwriting, administrating, acting as principle, and/or earning a continuing interest over and above what the client received. This had another distinct advantage. Once the new ARPS were first issued it could subsequently be re-marketed in the ARS market. As such, a prospectus would not be required before offering it to clients. Hence, clients got no prospectus nor were they told where it could be viewed. This supposed auction was not anything resembling a market based auction. It could not be since at core the structure was not market based. It was totally dependent on marketing it to a captured audience who did not suspect that there was a difference from one AAA “Auction Rate Security” to the other. Furthermore, clients never fathomed that these major houses would make alleged misrepresentations/omissions or potentially defraud them. Hence the deception was complete.
MISREPRESENTATION & MATERIAL OMISSION?
ARPS, it seems were marketed interchangeably with ARCS as if they were the same product. They were usually not referred to as ARC or ARPS to clients. Both were referred to by their ratings (almost all ARPS have AAA status) or Auction Rate Securities or both. The client, it seems, was simply told some or all of the following: it is as good as cash; think of it as a 28 day CD; No one has problems to get his money out at the auction date; it is like a money market.
If anyone asked what an Auction Rate Security was, brokers would generally explain that the principle is safe, but the issuer would vary the interest rate to what the market demands so you would be able to sell the security on the reset date. In fact most brokers themselves did not know exactly what the products really were, and how to explain the difference between ARCS, ARPS and a money market. No one, not even the broker, knew the actual risks of the product. It was simply represented as a money market type instruments? It would appear, at no point did the brokerage houses ever forewarn their sales staff and their clients that the ARS market was on the verge of collapse. If they had they could not have propped up the market.
WHY DID THIS PRODUCT THRIVE FOR SO MANY YEARS?
The Wall Street houses were making so much money from this process; they were determined to find a way to write as much business for as long as possible. However, if auctions failed this product would be short lived. In the case of ARPS specifically, clients would be caught with illiquid 50 years securities that would be worth 60% of what they paid. Who would ever consider these securities again?
Hence almost from the start it was necessary and essential to support and provide liquidity to give any hope for these securities to be accepted at the stated par value. Hence liquidity was an essential and integral part to make this market work as structured. Even if they had to buy 10% of the float it would not make much of a difference since they were earning so much from the rest of this process.
ARPS’ TRUE FAIR MARKET VALUE
It would appear that based on a true lack of liquidity, that from the very date of underwriting, these issues were worth approximately 60 cents on the dollar. The only reason that they would be worth the assigned par would be as a result of said liquidity that the brokerage houses initially provided. This allowed investors to exit on reset. Hence it justified the much lower short term rate of return for the respectively short term holding period. On their own the structures of these securities would be doomed from the start.
Over time there is no free lunch in an efficient market. If everyone could simply buy long term debt and finance it with cheaper short term debt everyone would be retired. There is a cost in guaranteeing liquidity while turning long term debt into short term debt. In an efficient market it will be close to the difference of the respective interest rates of said securities. Hence someone will end up paying for it, either the brokerage firm with guaranteed liquidity or their clients with 40% of their assets.
THE WEEK OF FEBRUARY 11, 2008
As opined above, the end of these securities truly started when they were underwritten. As a result, suspiciously, all the brokerage firms involved in this mirage of deception simultaneously decided to abandon their clients, and brokers a like, allowing them to sink with these contaminated securities.
WHY BROKERAGE FIRM SUPPORT ENDED
The brokerage firms had started losing credibility with the global markets as sub-prime mortgages were blowing up one after the other all over the world. One product after another followed suite whether it was security issues or other loans …. In addition, the rating agencies were also losing credibility. Brokerage firms could not raise unlimited funds any longer. Their reserves were running low. They lost some of the clout that allowed them to sell just about anything. Demand had started to dry up for everything including Auction Rate Securities. As a result, they decided to disassociate themselves from one of the products that was no longer profitable, claiming not to have a direct legal obligation. Hence, they determined to abandon the Auction Rate Securities market.
The fact is if these products were truly created for real markets there would be little or no problems. The reason they abandoned them completely is because they knew that these could not stand on their own and hence would require continued infusion of resources to prop up what has become an artificial market, rigged and manipulated for years. As a result of other debt debacles, the firms no longer had credibility to sell it on to the masses.
CONFUSION OVER ARC AND ARP BLOW-UP
Many think that because the port authority “Auction Rate Securities” ARCS blew up together with the closed end fund ARPS that it was a liquidity crunch and was indiscriminate to the type of security involved. The reason that the Port Authority ARC blew up is simply that ARCS and ARPS were in the same market. So when the brokerage firms pulled out it disrupted the entire market. For that moment ARCS were affected by the collateral damage precipitated by ARPS which in turn caused investors pause to try to figure out what had just happened. Most, but not all, of the ARCS reset at a higher rate. They did what it was supposed to by varying the rate enough to find a buyer. It seems 80% of the ARC auctions were successful. Only 2% of ARP auctions were successful. That is because ARPS is not market based. That’s not to say the ARCS market is without its misrepresentations and other problems.
VICTIMS OF FRAUD?
It is hard to believe but 99.99 % of tens of thousands of clients are still unaware that their ARS securities, listed at par on their statements, are not or were ever truly worth par. Without the brokerage liquidity they were worth less, and in the case of the ARPS were worth about 60 cents on the dollar. Also, eventually when the unknowing client will need the cash, suddenly their broker will advise them that the auction failed. And Fail it will time after time. That is unless they will have a secondary market in which they will have to sell these securities at a discount so that the interested investor will earn what he must for a 50 year illiquid security. It is not that the market has dried up. It is just that the manipulated market that artificially propped up 60 cents to be worth 1 dollar has abandoned them. In a sense they were sold a 50 year security that was paying them a fraction of what similar term securities pays out. The same principal, but to somewhat of a lesser degree, applies to ARCS.
The Brokerage liquidity was the only reason that it worked. Hence by artificially propping up these markets and not providing adequate disclosure they were in fact constructively representing the liquidity as essentially market based. They provided a false and misleading sense that there was a true free market that valued these securities at par. In fact the SEC cited 15 banks for rigging auctions and non disclosure. One such document is Administrative Proceeding File No. 3-12629. Yet the rigged auctions and artificial propping of liquidity had to continue since it was essential to make the structure work. That is the only reasonable conclusion one can obtain from the ARS market failures the moment the brokerage firms pulled out. Since the liquidity was not guaranteed it should not have been used as a selling point by the brokers. The brokerage firms used their assets to prop up this market, having done that they could have just as easily used these assets to cash out their deceived clients.
It is inconceivable to think that any client would be interested in these products if it had been properly disclosed, in a very direct and frank manner, that absent true liquidity these securities were worth as little as 60 cents on the dollar. Almost all investors in these products thought they were investing in a safe, secure and liquid investment akin to a money market. This is especially true since the rate of interest offered by these securities were just slightly higher than money market and indicative of what very safe short term securities paid. Risky securities offered more than double the return.
In essence investors took on double the risk for half of the return. There was no apparent risk/reward ratio.