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Home > Cases > Auction-Rate Securities > Citigroup Sounds the Death Bell for the Auction-Rate Bond Market

Citigroup Sounds the Death Bell for the Auction-Rate Bond Market

The fate of auction-rate securities shows no signs of being resuscitated, according to an April 15 article by Martin Blaun on Bloomberg.com. After an unprecedented number of auction failures, investors abandoned the $330 billion market for variable-rate municipal securities in February. Having already taken on nearly $250 billion in credit losses and write-downs, investment banks and securities firms like Goldman Sachs, UBS and Merrill Lynch were no longer willing to support the auction market and abruptly stopped infusing their own capital to buy the securities.

As a result, investors have been left with illiquid securities, while many issuers are forced to pay severe penalties in terms of exorbitant interest rates - some as high as 20 percent.

If the auction-rate market does cease to exist as Citigroup contends, the implications could be serious indeed for investment firms and brokers. Initially, the pain would be more than tolerable, with only a minuscule reduction in their earnings. But what they could face in the long term might be much more substantial - and that is the loss of trust from thousands of investors who decide they will no longer give these companies their business because of their mishandling of auction-rate securities.

In 2006, Citigroup was the top underwriter of municipal auction-rate securities, managing $8.4 billion of sales, according to the Bloomberg article.

Auction-rate securities are municipal bonds, corporate bonds, and preferred stocks in which interest rates or dividend yields reset through auctions held every seven, 14, 28, or 35 days.

From 1984 through 2006, only 13 auctions failed. Those failures, according to Moody's Investors Service, are attributed to changes in the credit of the borrower. As of April 15, 2008, more than 70 percent of auctions have failed.

As reported in the April 15 Bloomberg.com article, brokerage clients who hold between $100 billion to $150 billion of auction-rate securities control more than $750 billion in assets. Closed-end funds have issued about $40 billion of the securities.

Recently, several banks, including UBS AG, began informing customers that they could borrow against their now-illiquid auction-rate bonds. Nuveen Investments Inc. and seven other fund managers said they will redeem $7.8 billion in taxable preferred shares that have rates set through periodic dealer-run auctions.

To date, the auction-rate market has shrunk by at least 15 percent, or $51 billion, as U.S. municipal borrowers refinance to escape higher costs.

In the wake of the auction market's fall from grace, federal regulators and watchdog groups are calling for greater transparency and disclosure on the part of brokers and their interactions with clients. Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have initiated probes into the auction-rate securities industry, as well as asked for information from investment banks and securities firms regarding their protocol on marketing auction securities to customers.

Regardless of the outcome, these actions - which are late in the game at best - still may not be enough to satisfy thousands of investors who are facing catastrophic financial losses from the supposed liquid investments known as auction-rate securities. For them, an already ugly situation is likely to get even uglier.

Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.


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