InsideCounsel » June 2008

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 instruments take their name from the Dutch auctions at which investors buy and sell the instruments and auction agents set an interest rate. Because the auctions take place at regular intervals—typically every seven, 28 or 35 days—these long-term bonds behave more like short-term instruments and became a popular choice among investors for their liquidity, with broker/dealers marketing them as “good as cash” with a better return than money market funds. Issuers liked them too, since the floating interest rate meant they weren’t locked in for 30 years. ARS seemed like a win-win proposition.

“When the marketplace is functioning, auction-rate securities provide advantages both ways, and that’s why they were so attractive,” says Kevin LaCroix, an attorney and a partner in OakBridge Insurance Services in Ohio who has covered the auction-rate debacle on his blog, The D & O Diary. “The embedded risk was it depended on there being an auction-rate market where the interest rate could be set, and the failure of that marketplace is what has stymied everyone.”

Bidding Blues
Auctions first began to fail last summer, as confidence in the credit markets plummeted. Among the first wave of auction failures were the ones for CDOs like MetroPCS held. By fall the crisis began to work its way through the auction-rate market.

Suddenly investors trying to sell through the auction process found there were no takers, demonstrating for the first time that these so-called short-term investments in fact were not—and exposing a truth that changed what investors had come to believe about the $330 billion market.

Few investors were previously aware that the broker/dealers themselves regularly bid on any unwanted instruments at the auction, thereby ensuring liquidity and a robust market. As the auction-rate market began to show its weaknesses and the credit market confronted its own crisis, the broker/dealers stopped supporting the auctions and the marketplace came to a halt.

“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.

MetroPCS for its part announced in February an $83 million fourth-quarter loss related to its investments in ARS. And throughout early 2008, others have stepped forward to announce their ARS holdings: Bristol-Myers Squibb cut the value of its ARS from$811 million to $419 million; Best Buy has $417 million; JetBlue has $330 million.