The ARS Debacle: The Forgotten Crisis of 2008
Tucked away in the early days of the financial crisis, the auction rate securities (ARS) debacle has been largely relegated to the dim recesses of memory.
Compared to the subsequent financial calamities, the ARS fiasco was relatively small. And nine years later, it stands as little more than a “miniseries” of the Great Recession. However, investors and advisers should not downplay its significance.
It is a cautionary tale with valuable lessons.
An ARS is a type of variable-rate bond or adjustable-rate preferred stock with an interest rate that can change in response to financial market conditions. The underwriting broker-dealer structures these instruments with longer-term maturities of 20 to 30 years.
The rate paid to investors is reset at specific intervals throughout the life of the bond by a process known as a Dutch auction. This can occur at seven-, 14-, 28-, or 35-day intervals. At each interval, the broker-dealer submits bids to an auction agent. These bids are the lowest rate the issuer is willing to accept. Once the broker-dealer receives the bids, it then determines the clearing bid, or the rate at which the bonds are reset for the upcoming interval.
What is the allure of an ARS? You can borrow for the long term, yet enjoy lower finance costs through the shorter-term rates achieved at each auction.
Typical issuers are municipalities, student loan providers, closed-end mutual funds, and other institutional entities. Bond funds, bank trust departments, and high-net-worth individual (HNWI) investors — the latter compose much of the market — are the most common purchasers. The enticement is a highly liquid, cash-equivalent instrument with a better yield than short-term paper and over a longer time frame.
The ARS market enjoyed a mostly unblemished record from its inception in the 1980s until the onset of the financial crisis. By that time, it had grown to $330 billion in outstanding securities. In early 2008, auctions for municipal ARS froze, making it difficult for issuers to reset their rates and leaving retail investors unable to redeem what they believed were highly liquid investments.
How did a seemingly benign corner of the fixed-income market come to grief?
Financial market interrelationships had much to do with it. As the subprime rot spread and mono-line insurers were increasingly exposed to bad loans, they faced rating agency downgrades. Investors doubted that these insurers could offer adequate protection for securities beyond just asset-backed issues.
This suspicion extended to ARS. There was no explicit safety net for the market, but rather an implicit one.
Auction dealers would normally intervene in an auction with a few bids to ensure its success. These same dealers would emphasize the low number of failures in the history of this security — only 13 out of more than 100,000 auctions between 1984 and 2007. As other financial pressures began to weigh upon the very dealers who would backstop the auctions, however, the stress on their balance sheets caused them to abandon their support of auctions en masse in February 2008.
The increasing inability of institutions to provide liquidity due to falling asset prices further exacerbated their financial distress, driving down asset prices even further and sending liquidity into a downward spiral. By mid-February 2008, the rate of ARS auction failures climbed to about 85%.
The results? Risk-averse investors couldn’t sell these issues to raise cash for near-term expenses, and issuers were often stuck paying double-digit rates as the investors who remained in the market exacted a greater risk premium.
In 2008 alone, the SEC received over 1,000 complaints. By 2009, large financial institutions settled with the agency, making roughly $50 billion available to pay aggrieved ARS investors who claimed that these firms mislead them about how these securities worked and what risks they bore.
The takeaways from this meltdown are clear.
Lessons for Advisers
- Know what you’re selling. While the ARS framework seemed relatively straightforward, the offering documents contained essential details about their structure and operation. There were real risks embedded within that investors should have known about. Moreover, depending on the issuer, certain forms of ARS were harder to redeem either directly or through the secondary market where discounts range from 5% to 15%.
- Be a student of global markets. Financial contagion is real and insidious. It can leech into areas of the financial markets seemingly immune to risk. Advisers need to understand how interconnected markets and world economies have become. From a spark can roar a mighty fire.
- Educate your client. This advice goes hand in glove with the first lesson. Clients need to know how to enter the house and how to exit.
- Tell the truth. Many clients were unaware of the ARS trap. Why? In part, because advisers led them to believe that these securities were highly liquid and safe. Indeed, many of the larger investment banks settled with investors over sales practice violations. Advisers may also have failed to consider the suitability of ARS for their clients.
- Reputational risk occurs when advisers put their well-being ahead of their investors. Steer clients toward prudent courses of action and away from imprudent ones. It sounds patently obvious, yet look what happened.
Lessons for Investors
- Investor beware. Know your objectives and risk tolerance: Assess and review them with your adviser annually, if not more frequently. What do you want and expect from your investments?
- Question your adviser about their proposed recommendations. How do they work? What are the benefits and the risks? What is a worst-case scenario? ARS holders learned the hard way. The tedium of reading offering documents is far preferable to a liquidity trap.
- Know your adviser. Period. What is their professional and educational background? Are they a generalist or specialist? How are they paid? Have they had brushes with professional associations or regulators?
- Too often investments are sold that shouldn’t be. Any investment must be part of an overarching policy statement that considers the client’s objectives and constraints. Notwithstanding attempts to weaken or kill it altogether, the Department of Labor (DOL) Fiduciary Rule, slated to take effect 10 April 2017, looks to be a positive step in this direction.
The key takeaway from the ARS fiasco is that both advisers and investors need to do their homework and work together. They should remember that financial history is littered with calamities and malpractice. Sequels rarely turn out well.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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