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Auction Rate Securities: From Boom to Bust…to Broke?

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Washington, DCWhile it may have occurred well before the market for auction rate securities turned to dust, alleged misdeeds by a major brokerage firm has resulted in a settlement with the Securities Exchange Commission (SEC).

First Southwest has agreed to compensate the SEC $150,000 to settle charges that the firm had allegedly engaged in various auction rate securities practices that may have affected investors' returns.

Securities BrokeIt was announced May 27th that from January 1st 2003 through June 30th 2004, First Southwest was believed to have intervened in auctions by bidding for its proprietary account to prevent failed auctions, and to prevent all-hold auctions. The latter represents a below-market rate established when all current holders of auction rate products trigger the intent to hold their positions, ensuring that there are no securities for sale in the auction. The former scenario would see the issuer having to pay an above-market rate set by a pre-determined formula.

First Southwest issued a statement, which said in part, that the firm is committed "to ensuring that our auction rate practices meet with the highest industry standards…We have always supported the efforts of the Securities Exchange Commission to improve disclosure in capital markets, and are pleased to have this matter resolved."

The auction rate market is currently on life-support, if not completely dead. But before conditions entered into the market that would prove terminal, the auction rate securities market was a $300 billion-plus juggernaut. A symptom of that largesse was a fair bit of alleged hanky panky on the part of numerous firms that resulted in a $13 million dollar global settlement with 15 broker-dealer firms over similar charges in 2006.

First Southwest was not included in the above-noted settlement, as the firm did not disclose its practices until well after the settlement with the SEC was reached. Still, the investigations continue. The first Southwest agreement is the fourth settlement with market firms tied to undisclosed activity.

The recent settlements do not include a probe, which began earlier this year after the auction-rate securities market succumbed, into how auction rate securities were sold to investors. There are many questions surrounding those sales, given the claims from many that auction rate securities were promoted as 'good as cash' by many brokers, some going so far as to verbally guarantee that claim even though the truth was far from that mark. Yes, those securities were as good as cash, so long as there was a buyer. And in the midst of a hot market, there was little doubt that willing buyers could be found.

Amidst a softening market and the absence of buyers, suddenly 'good as cash' securities were anything but good as cash, and were revealed instead as true securities—some with 30-year terms. The good news is that investors could recover their money. The bad news—with zero buyers willing to support the market; the investor might have to wait thirty years for the note to mature.

Some frustrated investors report having never seen a prospectus, let alone granted a cautionary word that those securities, regardless of the robustness of the market, carry certain risks.

The SEC, meanwhile, has been quietly policing the industry, and 16 months ago reached a $1.l6 million settlement with three auction agents—Deutsche Bank Trust Company Americas, The Bank of New York, and Wilmington Trust Co. The allegation was that the trio violated securities laws by accepting broker-dealer bids after deadlines, and allowed dealers to intervene in auctions. Such intervention could have negatively impacted rates.
Until the market dried up earlier in the year, auction rate securities proved to be an extremely popular alternative to variable-rate financing, and for investors represented an alternative to money market funds. Auction rate securities are bonds upon which interest rates are periodically set through auctions, typically every seven, 14, 28 or 35 days.

Several investors have been displeased that their brokerage firm or lender were not inclined to honor the securities in spite of a soft market, and are plunging the knife in a little deeper by extending preferred lending rates to clients whose money is locked into an inaccessible product. The latter gives off the appearance that the lender is profiting twice from the investor's ill fortune.

In the meantime, the SEC appears poised to keep sweeping the securities mine field for signs of trouble and levying fines as required, such as the $200,000 fine levied against Citi, which has since merged with Legg Mason Wood Walker Inc. The latter was also collared, in 2005, for suspicion of auction intervention—if not now, at least in the recent past, before auction rate securities went the way of affordable gas…



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