The auction-rate preferred-security crisis may yet have a happy ending.
This is welcome news for every fixed-income investor and anyone who depends on healthy credit markets. It's especially good news for the holders of $330 billion in ARPS who were among the victims of the credit crisis that gripped financial markets this year. When the credit markets seized, big brokerage firms and investment banks stopped providing liquidity, the auctions failed, and the securities were essentially frozen in accounts. Many people lost access to their life savings.
Here's what's happening now: Major issuers of ARPS, including industry leader BlackRock, are in the process of partially redeeming the frozen ARPS by refinancing them with tender-option bonds.
BlackRock said it will refinance $1.6 billion of its tax-exempt ARPS by the end of July, bringing total redemptions to $2.4 billion, or about 25 percent of the total issued by BlackRock. How much is being redeemed depends on the particular security. BlackRock said investors will regain access to as much as 42 percent of the face value and as little as 2 percent through these tender-option bonds. (Investors should check the Web sites of the issuers for a breakdown of redemption rates and payment schedules.)
Obviously, this is only a first step. But Steven Baffico, a BlackRock director in charge of closed-end funds, told me progress is also being made toward converting the rest of the ARPS into money-market eligible paper. The Securities and Exchange Commission and Treasury issued rulings last week that should help the process. Some hurdles remain, the chief one being attracting liquidity from the same institutions that walked out on the auctions, but Baffico said he's optimistic.
“Progress has been good, measurable and consistent,” Baffico said.
I've been hammering away on this subject in this column not just because I'm one of the victims, but because the injustice was so painful to many investors. Investors were told by their brokers that these investments were the equivalent of money-market funds, highly liquid and safe. This was reflected in the yields, which were barely higher than the money-market equivalent. No one expected to get rich investing in ARPS. It was just a convenient place to park cash while earning a slightly higher return.
The ARPS I bought, and all of them with which I'm familiar, were backed by triple-A-rated securities. Virtually none of the bonds that made up the underlying portfolios defaulted. The ARPS have continued to pay interest throughout the crisis.
So why did the auctions fail? As best I can tell, as panic swept the bond markets in the wake of the subprime crisis, all structured-debt products were suspect, the sound as well as the shaky. Once one of the big investment banks stopped bidding, everyone else stopped committing capital to what threatened to become illiquid securities, further depleting their weakened balance sheets. Once several auctions failed, many ARPS investors wanted their money back. It was the equivalent of a run on the bank. (Under the contractual terms of the securities, the auctions are still held every week, and continue to fail.)
With benefit of hindsight, there was no need to panic because the issuers have kept paying interest and defaults on the underlying bonds have been negligible. Of course, none of us will probably buy another ARPS again, which means the market is essentially dead. In a sense this is too bad, because ARPS helped provide the liquidity that enabled a wide array of institutions, from schools to hospitals, to fund their operations.
Hundreds of investors wrote me about their plight, and I applaud them for helping keep up the pressure on their brokers, the issuers, the investment banks and in Congress. This we still need to do until the ARPS crisis is resolved.
James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, writes weekly about his personal investing strategy.
