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. And with India
not lacking in its share of admirers of those markets,
it is perhaps necessary to look at what these instruments
can teach us here as well.
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.
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