Auction-Rate Insecurities

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After a $1.15 billion IPO in April 2007, wireless service provider MetroPCS Communications Inc. found itself with a surplus of cash and decided to invest it wisely. It specified to investment adviser Merrill Lynch its interest in low-risk investment vehicles that would preserve capital and provide liquidity while offering modest returns.

In May 2007 Merrill Lynch began purchasing on behalf of MetroPCS nearly $134 million in auction-rate securities, which ostensibly fit the bill. Anyone who's read the financial pages lately knows the turn this story is about to take.

Auction-rate securities (ARS), which have been around since 1984, are generally municipal bonds, although there are other forms such as student loan-backed securities. MetroPCS had cash in 10 ARS, nine of which were subprime mortgage-backed collateralized debt obligations, a rarer category of ARS.

"The instrument is flawed, but for nearly 30 years it worked well because it had never been stress-tested," says Tony Carfang, partner and director at Treasury Strategies, a consultancy that alerted the Financial Accounting Standards Board to the pitfalls of ARS in January 2007. "Now all the weak links are being exposed."

By February the market was declared dead, and with experts split on whether it can ever be revived, major brokerage firms as well as the companies and individual investors that can't access their cash are facing a financial meltdown.

Still, claims from companies remain a novelty. "One of the reasons you haven't seen corporations filing against the securities dealers is they've just been too busy explaining internally what's going on with these securities within their own company and filing their first-quarter financial reports," Carfang says.

"You may see a change in that pattern. At the same time, a company would have a higher burden to demonstrate that it was misled."

Associate Editor

Melissa Maleske

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