On April 24, representative Barney Frank, chairman of the House Committee on Financial Services, sent a letter to Chris Cox, chairman of the Securities and Exchange Commission (SEC), asking what exactly the securities industry regulator was doing to remedy the situation.
In particular, Frank questioned why one potential solution - the redemption of ARS notes backed by corporate preferred shares by the issuing corporation - was not been explored. Corporate preferred ARS issuers have insisted that redeeming the now-illiquid securities would be detrimental to the common shareholders of their firm - essentially bailing out one set of investors at the expense of another.
Frank's letter is just the latest in a series of regulatory actions getting under way across the US. On April 17, the North American Securities Administrators Association (NASAA) announced the establishment of an investigatory task force, "to help investors who cannot access funds that their brokers placed in these complex investment products".
The task force, including state securities regulators from Florida, Georgia, Illinois, Massachusetts, Missouri, New Hampshire, New Jersey, Texas and Washington, will focus on the sales practices used by brokers and the supervisory structure around the ARS market.
“Our focus is to determine what conduct took place at the point of sale – what was potentially misrepresented and omitted – and our goal is securing for investors access to their cash as requested. If the product was represented to be a cash equivalent going in, it must be treated as a cash equivalent coming out,” said NASAA president Karen Tyler in a statement.
But deceptive sales practices are a peripheral issue in the market seize-up. Brokers had good reason to believe that ARS were just as liquid as money markets, given that only 13 auctions failed between 1984 and mid-2007.
The unexpected withdrawal of auction agents from the market was also extremely hard to foresee. The crisis was precipitated by institutional holders of short-term floating rate securities called variable rate demand notes (VRDNs) passing the paper back to dealers due to concerns over the ratings of monoline insurers back in January.
Money-market funds, alarmed by the downgrades of financial guarantors, exercised the put option on their VRDNs and fed them back to dealers en masse, inevitably leading dealer balance sheets to rapidly become bloated.
That capital drain meant that the same dealers, acting as auction agents in the ARS market, were unable to continue acting as buyers of last resort for the paper and withdrew from the market, allowing it to grind to a halt.
Whether brokers could have foreseen this, and whether they sold ARS to investors in the knowledge that the market was on the verge of paralysis, will be the biggest questions the NASAA investigation will have to address.
Meanwhile, New York attorney-general Andrew Cuomo's investigation into the auction agent Wall Street banks continues. On April 18, the Attorney General's Office issued subpoenas to 18 banks, seeking to ascertain their level of involvement and the events surrounding the wholesale withdrawal of investment firms from their traditional backstop role in the ARS sector.
Despite widespread consensus among dealers that confidence in the ARS market has been irreparably damaged and that an orderly dissolution of the market is now under way, some low-level secondary market activity is being undertaken.
In March, the Restricted Securities Trading Network (RSTN), an online trading platform for investors looking to invest in illiquid securities, began trading ARS, giving investors caught holding auction paper the chance to liquidate their positions - albeit at a significantly discounted price.
According to the RSTN, around 10 ARS trades are being conducted on its platform every day, as hedge funds and other opportunistic investors seek to pick up the securities priced as much as 25% less than their original value.
Significantly, the credit fundamentals of most securities, especially those issued by municipals or backed by government-guaranteed student loans, are extremely good, proving a strong lure for those investors unconcerned about having their capital tied up for the foreseeable future.