Structured Auction Rate Securities: The Next Shameful Chapter for Wall Street

by Jacob Zamansky on September 11th, 2008 at 8:14 am : Comments 000

As I posted about before, notably left out of the regulator’s Wall Street settlements are holders of structured auction rate securities, which go by any number of names such as “auction pass through trusts” and “Rule 144 private placement auction rate securities.”  These securities are unlike traditional ARS’s in that they are not issued by municipalities or closed end mutual funds, but are derived from individual securities, commonly preferred stock.  Make no mistake, these are separate products from auction rate securities; they are similar in name only and firms such as Merrill Lynch, Credit Suisse and Lehman Bros. were aggressive sellers.

The vehicle for structured auction rate securities are “pass-through trusts,” which means they are issued as private placements outside the regulatory framework.  Generally only institutional investors and high net worth individuals qualified to purchase structured auction rate securities.  Our investigation has found many were duped into buying them after they were pitched as…you guessed it…cash equivalents.  A common target were conservative investors like endowment funds and foundations.

The most shocking feature of structured auction rate securities is that often the underlying asset that determines valuations are tied to the subprime mortgage market.  For example, at least one brokerage firm aggressively sold structured auction rate securities tied to Fannie Mae and Freddie Mac’s preferred stock, which is well on its way to being worthless.  Many of these so-called “auction pass through trusts” received AA and AAA ratings from the major rating agencies which made them attractive to institutional investors.  Indeed, these were far from being anywhere near “cash equivalents,” which is how they were marketed.

I have a few theories as to why the holders of structured auction rate securities were left out of the auction rate securities settlements with the regulators.  In particular, structured auction rate securities are likely to lead to substantial “real” losses.  By comparison, the auction rate securities Wall Street bought back from its customers at the behest of regulators were purchased at par.  There was no decline in their value so firms like Merrill Lynch and UBS will not suffer losses.  If Wall Street was forced to buy the billions of dollars worth of structured auction rate securities, the write downs would be immediate and severe; in some cases the underlying assets are only worth cents on the dollar.

Arguably, institutional investors that purchased structured auction rate securities were misled on a larger scale than the retail investors covered in the ARS settlements because of the toxic underlying subprime and CDO-related assets.  These investors wanted an instrument similar to a money market fund and were not told they were buying a derivative whose reference security was a preferred stock of a financial institution.  To be sure, preferred stocks still carry inherent risk as the preferred holders in Fannie Mae and Freddie Mac are learning.  And if investors had an appetite for this kind of risk, they could have simply bought preferred stock rather than a derivative such as structured auction rate securities, which are now near worthless and illiquid.

We’ve been contacted by several institutional investors holding structured auction rate securities and its likely many others will be filing arbitration claims against their brokers.  Based on our investigation, billions of dollars worth of structured auction rate securities were underwritten and issued by Wall Street. This represents a huge liability for brokerages, a gaping hole in the regulator’s settlements and a total disregard for investor suitability standards.

Filed under Auction Rate Securities, Investment Fraud, Securities Arbitration, Structured Auction Rate Notes, Structured Products Arbitration
and auction pass through notes, Auction Rate Securities, Fannie Mae Preferred Trusts, Freddie Mac Preferred Trust, pass-through trusts, Rule 144, structured auction rate securities