Hundreds of auctions have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales. Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.
Inadequate disclosure ``may have masked the impact of broker-dealer bidding on rates and liquidity,'' Martha Haines, head of the Securities and Exchange Commission's municipal office, said in an interview. ``The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.''
Citizens Property Insurance of Tallahassee, Florida, a state-run insurer that protects homeowners against hurricane losses, is a casualty. The rate Citizens pays on a portion of the $4.75 billion in securities it has sold jumped to 15 percent from 5 percent at an auction run by UBS that failed on Feb. 13.
No `Backstop'
``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.''
Officials at Goldman, Citigroup, UBS and Merrill declined to comment. All the firms are based in New York, except UBS, which is located in Zurich. UBS told its brokers this month that it won't buy bonds that fail to attract enough bidders, and Merrill said it was reducing its purchases.
Auction-rate securities are long-term bonds whose interest resets every seven, 28 or 35 days at bidding run by a dealer who collects a fee of about 25 basis points. Unlike Treasuries or stocks, there is no daily source of information about auction- rate bonds. Issuers have relied on banks to be buyers of last resort when bidders couldn't be found at their auctions.
Since the first of the securities were sold in 1984 for American Express Co., the market has expanded as investors sought the bonds as a higher-yielding alternative to money funds.
SEC Fines
Along the way, New York-based Lehman Brothers Holdings Inc. was fined $850,000 in 1995 by the SEC for manipulating auctions conducted for American Express. Almost two years ago, 15 securities firms paid the SEC $13 million to settle claims of bid-rigging in auction-rate bonds. The banks neither admitted nor denied wrongdoing.
While the SEC required dealers to disclose that they may use insider knowledge to place bids, they don't have to say how frequently they bid or how much. Dealers also aren't obligated to disclose rates on auction debt when the securities trade.
The settlement didn't go far enough because it still deprives investors of information they need to make informed bids, said Joseph Fichera, chief executive of Saber Partners LLC, an advisory firm in New York.
``Investors aren't sure they can sell the bonds when they want,'' Fichera said.
Aside from the fines, the market worked smoothly until November, when investors began pulling back from all except the safest of government debt as losses on securities tied to subprime mortgages began infecting other parts of the credit market.
Subprime Contagion
Wall Street firms, reeling from $146 billion in losses on their debt holdings, became unwilling to commit their own capital to support auctions that don't attract enough bidders.
``It's more a liquidity issue, I don't think there's a concern here about these entities being able to repay their debts,'' said Tony Crescenzi, chief bond-market strategist in New York at Miller Tabak & Co., in an interview today with Bloomberg Radio. ``These auction-rate securities are proving to no longer be viable, and we'll see them diminish in scope and size as we go forward.''
A month ago, it was ``unthinkable'' that the banks wouldn't intervene to support auctions, said Steven Brooks, executive director of the North Carolina State Education Assistance Agency. ``I had certainly hoped and believed that that liquidity was there and was an important part of why this marketplace was good for investors and good for issuers.''
From 1984 through 2006, only 13 auctions failed, typically because of changes in the credit of the borrower, according to Moody's Investors Service. There were 31 failures in the second half of 2007, and 32 during a two-week period beginning in January.
`Ugly' Market
``It's ugly,'' said Luis I. Alfaro-Martinez, finance director for the Government Development Bank of Puerto Rico, which saw the rate it pays on $62 million of debt rise to the maximum of 12 percent set out in documents governing the bonds, from 4 percent at a Feb. 12 auction handled by Goldman. ``It's getting uglier.''
The average rate for seven-day municipal auction bonds rose to a record 6.59 percent on Feb. 13 from 4.03 percent the previous week, according to indexes compiled by the Securities Industry and Financial Markets Association.
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