Remember Auction Rate Preferred notes? These investments seemed to offer something for nothing. Their interest rate would float at a spread above LIBOR and be reset weekly. If investors wanted their money back, there were supposedly a host of other investors ready to purchase the securities at their next auction.
But it didn’t work out that way. When the financial crisis hit, a lot of the auctions failed. Short-term notes became long-term loans. Bonds that were as good as cash suddenly traded at a deep discount.
Borrowers were unhappy, too. Their weekly-reset cash-like interest rates suddenly went to penalty levels four or five percent above the benchmark. That was bad. but it got worse: many of these credits were municipalities that had swapped their floating rate liabilities into fixed rate exposure. These “pay-fixed, receive-floating” interest rate swaps were now bleeding cash, even as the towns needed to pay more to their bondholders.
So we had angry bondholders and angry borrowers. Naturally, they sued the brokers who set up this process. At first the brokers claimed that failed auctions hadn’t happened before, so they couldn’t be held responsible. Only they had: in 1990, Citibank and some small utilities got into trouble when their preferred auctions failed. The brokers should have known better.
So many brokers bought the discounted bonds back at par, bailing the investors out. Swap counterparties also settled for pennies on the dollar, as cash-strapped municipalities cancelled swap contracts. This “sure thing” backfired for everyone involved.
Some of the lawsuits are finally being adjudicated, and it isn’t going well for the dealers. This disastrous product was sold to unwary investors because many were reaching for yield, which often ends in tears. While this particular chapter remains closed, today’s yield-hungry investors should be on the watch for products like these. Let’s not forget the foolishness of the past, lest we repeat these kinds of mistakes in the future. We don’t need any more tears.
Douglas R. Tengdin, CFA
Chief Investment Officer
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