From the SEC:
Washington, D.C., June 3, 2009 – The Securities and Exchange Commission today announced finalized settlements with Bank of America, RBC Capital Markets, and Deutsche Bank to resolve SEC charges that the firms misled investors regarding the liquidity risks associated with auction rate securities (ARS) that they underwrote, marketed, or sold.First, though, for those who have let the ARS saga pass them by (or else just plain forgotten it – it was a good year ago now), a recap:
“ARS” stands for auction rate security. The basic principle is as follows: an ARS is typically a long-term nominal maturity bond, the interest rate on which is regularly reset. This is done through a Dutch auction, in which the auctioneer begins with a high asking price which is gradually reduced until an auction participant accepts it.
(Appropriately enough, the term dutch auction is derived from the fact that it was the favoured method of selling tulip bulbs in Holland circa 1636)
In the case of ARS, such auctions are typically held on a pretty regular basis — every 7, 28 or 35 days. Holders of ARS can either sit on their notes, or sell them back into the auction process at which a new interest rate for their securities will be determined. Banks traditionally played market maker in the ARS process, and as such, ARS were marketed as highly liquid.
Therein the problem. Traditionally, ARS were issued by municipal authorities. But by 2007, of the $200bn ARS market, investors had begun to fret about the health – and ratings – of the bond insurers who guaranteed some 80 per cent of the entire market.
As investor confidence collapsed, buyers for ARS in auctions withdrew and as a result, the auctions failed, and saw interest rates automatically reset at pre-determined “maximum” levels. For municipal ARS issuers this meant a massive new debt servicing burden and for ARS buyers it suddenly meant an illiquid, priceless market.
Enter the SEC. It accused the banks of misrepresenting the safety and liquidity of the market to both investors and issuers and it chastised them for pulling the plug on auctions by refusing to fulfil their traditional role as market makers. The result was that by August last year, a clutch of the top ARS sponsoring banks had agreed to repurchase billions in ARS securities.
The process has been trundling along and has been taking a while to come to a head. So far Wachovia, Citi and UBS have settled with the SEC. And today, finally, so too did BofA, RBC and Deutsche. QED:
Without admitting or denying the SEC’s allegations, Bank of America, RBC and Deutsche Bank agreed to be permanently enjoined from violations of the broker-dealer fraud provisions and to comply with a number of undertakings, some of which are set forth below.
-Each firm will offer to purchase ARS at par from individuals, charities, and small or medium businesses that purchased those ARS from the firm, even if those customers moved their accounts
-Each firm will use its best efforts to provide liquidity solutions for institutional and other customers and will not take advantage of liquidity solutions for its own inventory before making those solutions available to these customers.
-Each firm will pay eligible customers who sold their ARS below par the difference between par and the sale price of the ARS.
Those settlements? Well, not as huge as those slapped on UBS or Citi, to be sure, but hefty in their own right, nevertheless:
-$4.5bn from Bank of America
-$1.3bn from Deutsche Bank
-$800m from RBC
Such legal costs are going to be the forgotten drag on banks’ profits for months – if not years – to come, we suspect. There is a whole universe of furious buy-siders out there who have been burned by structured finance and various exotic products sold to them by investment banks over the past few years.
Take, for example, Jefferson County, Alabama (unenviably, one of the most indebted counties in the US).
Roll on the lawsuits.