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Washington, DC - House Financial Services Committee Chairman Barney Frank (D-MA), along with Ranking Member Spencer Bachus and Capital Markets Subcommittee Chairman Paul E. Kanjorski today announced the Committee on Financial Services will hold a hearing in September to examine the continuing crisis in the markets for auction rate bonds and auction rate preferred securities.
To date, thousands of investors, student lenders and municipal bond issuers face a financial hardship as a result of the breakdown of the auction market six months ago. While industry has worked closely with regulators to find solutions with some success since then, the slow pace of progress is not acceptable. The Financial Services Committee will look into what needs to happen to resolve this problem. The first hearing is scheduled for September 18, 2008 at 10:00 a.m. Chairman Frank also announced the committee will hold follow up hearings as necessary.
Specifically, the hearings will not only look into the causes of this market failure—whether they be regulatory or the imprudent activities of brokers and bond insurers—but more importantly the potential solutions. Chairman Frank noted today that there have been encouraging signs from the Treasury and the SEC that those institutions understand that an unprecedented problem requires a creative solution. The remaining problem is significant, however, and continues to take a toll on undeserving individuals and cities, hospitals, colleges and universities and other issuers. The Committee will hear from a variety of witnesses including regulators, broker-dealers and issuers of these securities.
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Background on Auction Rate Markets
The auction rate markets have been around for about three decades and are so named because the securities depend on investor willingness to participate in regular auctions. So long as the auctions attracted sufficient interest, securities remained liquid—or could be easily bought and sold. Working auctions allowed issuers to pay lower short-term interest rates on securities with long maturity dates for which investors would normally demand higher yields.
The auctions were typically run by broker-dealers and would occur every seven to 28 days. It was common for banks to bid in auctions that lacked sufficient investor participation and hold the securities on balance sheet. As the credit crisis strengthened its grip on the financial system last year, however, individual investors—some concerned over the possible credit downgrade of bond insurers—increasingly withdrew from the auctions. This made bank participation in the auction markets more important than ever precisely at the time they were coming under unprecedented financial stress and unable to hold additional auction rate securities on balance sheet. This led to the auction market’s complete collapse.
Auction Rate Securities
Auction rate securities are long-term bonds that pay short-term interest rates that reset at auctions. With the general exception of bonds backed by student loans, most required the issuers to pay interest at a “penalty” rate in the event an auction failed—something that rarely happened. The mainly local governments, hospitals and universities that issued these bonds had a strong incentive to restructure the securities when this happened. As a result, what had been an approximately $270 billion market has shrunk to about $130 billion—with the bulk of those remaining bonds backed by student loans.
Auction Rate Preferred Securities
It is investors, not issuers, who have suffered as a result of the seizing of the market for Auction rate preferred securities (ARPS). ARPS are equity securities issued by closed-end mutual funds that typically have no maturity date. When this market froze completely on February 14, 2008, about $64 billion in investor money was locked up. Since then, mutual funds and brokers-dealers have redeemed—or pledge to redeem—about $20 billion in the securities, according to Herzfeld Advisors[1].
Committee Actions
Chairman Frank has led the Congressional response to this crisis since the outset. On February 28, Chairman Frank, Chairman Kanjorski and Ranking Member Bachus wrote the SEC urging that issuers be permitted to bid in auctions for their own securities. The SEC responded favorably permitting many hospitals and universities to lower their financing costs significantly.
On April 21, Chairman Frank and Chairman Kanjorski wrote the SEC urging fast action on pending requests from mutual funds seeking regulatory clearance to issue new securities that could facilitate the redemption of ARPS. Ranking Member Bachus wrote a similar letter independently. The SEC responded on June 13[2] with the no-action letter that would allow the mutual fund companies to go forward. To date, one company has announced plans to issue the securities later this summer.[3]
Chairman Frank also wrote to the 10 mutual fund companies who are the largest issuers of ARPS urging them to act as quickly as possible to resolve the problem as well.
Federal Regulatory Actions
On April 11, the SEC and the Financial Industry Regulatory Authority (FINRA) announced a joint enforcement sweep of sales practices of auction rate securities. The sweep request letter went out to 24 firms.
- Approximately one third of the 24 targeted firms have a national presence; the remainder are regional firms and smaller.
- As of July 18, FINRA received over 300 customer complaints involving over 40 different firms.
- The firm with the highest number of complaints had 56; the next two firms with the largest number of complaints have 23. The top nine firms account for nearly 70% of the total complaints.
- Over 160 arbitration claims related to auction rate securities have been filed since March of this year.
FINRA has also issued guidance on to securities firms on how the proceeds of the redemption of ARPS should be distributed[4] and the terms under which investors can request their broker sell their securities in the secondary market[5].
State Regulatory Action
The North American Securities Administrators Association formed the ARS Task Force in April to coordinate a series of investigations into possible violations of state securities law in connection with the offer and sale of auction rate securities.
Four enforcement actions arising from the ARS investigations have already been filed.
- On June 26, 2008, Massachusetts filed against UBS.
- On July 22, 2008, Texas filed against UBS.
- On July 24, 2008, New York filed against UBS.
- On July 31, 2008, Massachusetts filed against Merrill Lynch.
- These cases include allegations that the firms committed fraud in connection with the offer and sale of ARS securities. They also include allegations that implicate upper level management in the ARS violations.
1-Investor Guide to Closed-End Funds (July 2008) Thomas J. Herzfeld Advisors
2- See http://www.sec.gov/divisions/investment/noaction/2008/eatonvance061308.pdf
3- See Nuveen press release of July 9, 2008.
4- See http://www.finra.org/RulesRegulation/NoticestoMembers/2008Notices/P038406
5- See http://www.finra.org/web/groups/rules_regs/documents/notice_to_members/p038699.pdf
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