Do Banks Face Huge Legal Liabilities From Auction-Rate Bond Market?

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A number of large money center banks and brokers walked away from the role of using their capital to support the auction-rate markets. This market has been in place since 1984. Its size is now estimated at $324 billion.

Although the paperwork for these bonds says that the banks have no obligation to create and maintain the market, the question is whether the actions of the banks involved misleading marketing or a failure to disclose the risks of these instruments.

Two weeks ago, these markets, which had only seen thirteen failed auctions over twenty-four years ,had 480 failed auctions on February 20. The reason is that “The banks were the backstop,” said Sharon Binnun, the chief financial officer of Citizens. “If you had more sell orders than buy orders, they’d pick up the difference and you wouldn’t have a failed auction," according to Bloomberg.

This problem is not going to go away soon. The banks do not feel that they have the capital to support the auction-rate market. Trading in one of the three parts of the market, muni-bonds, has begun to move again, but only very slightly. Because of the financial dynamics of the other two parts of the market, $86 million of securities backed by the Federal Family Education Loan Program and private student loans, and about $80 billion of preferred stock and notes issued by closed-end funds, there are no incentives for the auction-rate buyers and sellers to start trading again.

At this point, a number many investors who believed that auction-rate securities were as liquid as cash cannot get access to the money they invested in the bonds. Corporation which held auction-rate bonds as "cash equivalents" are now faced with writing down the value of the holdings and cutting capital spending because they do not have access to capital. Alternative energy firm Aventine (NYSE: AVR) said it would probably delay building two plants because it could not sell auction-rate securities. The problems is likely to spread, and, if the market does not trade for a period of several more weeks, hundreds of public corporations may face write-downs in Q1.

One of the large accounting firms has recently issued a warning according to DealBreaker: Deloitte told auditors that “because many entities assumed that these securities were economically equivalent to cash (even if they are not the accounting equivalent of cash), investments may not be on the “radar screen” as companies consider their loss exposures in the current environment.”

The role that banks played in the auction-rate market is not entirely different from the role that specialists have on a stock exchange. They take inventory which is not being bought and hold it until the next round of trading. It keeps the market orderly and liquid.

Investors, both corporate and individual, are certainly looking for the legal liabilities the banks may have in this fiasco. They could point to the fact that the banks abandoned a market which they had essentially supported without interruption for 23 years. The banks would say that it was clear they had no legal obligation to stay in the market, and they might be right.

What the banks do understand. along with attorneys, is that these securities were marketed and treated as "cash equivalents". The banks did nothing to indicate to a huge number of buyers that this marketing was wrong even though it had been part of the appeal of auction-rate securities for well over two decades.

The banks and brokers who operated the auction-rate markets turned their backs on customers in a matter of days, clearly to save their own balance sheets. They may have created new legal problems by doing this..

Shafting the customer does not always work.

Douglas A. McIntyre