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An ARS Bailout—For A Price

A secondary market has popped up for retail investors who want out of auction-rate securities–now. Are the deals worth it? That depends.

Barry S. Silbert is emerging as an unlikely hero in the auction-rate securities collapse. At 32, he quietly patrols the trading room at Battery Place in lower Manhattan as his band of 15 traders, glued to their computer screens, takes calls from financial advisors with questions.

The advisors want to know how to price ARS to attract buyers, what potential investor demand looks like, even how to locate a missing prospectus. Understandably nervous, the advisors welcome the traders' front-line support.

ARS weren't even on Silbert's radar back in 2005, when he first opened Restricted Securities Trading Network (RSTN), an online platform that brokers trades in restricted securities for accredited investors. Even as recently as six months ago, he says he was hearing very little about ARS. “Then the market went through this rough patch, investors needed cash and we were in the right place at the right time,” he says.

That's for sure. Advisors, investors and other pros are now posting as much as $4 billion worth of these discredited ARS products for sale each week, below par, on Silbert's eBay-like system, hoping to monetize their investments without taking too much of a loss. About 1,000-plus transactions — some as large as $200 million each — have been completed since the launch in early March. “We can get the liquidity and we can get advisors out of any auction-rate securities they hold,” says Silbert, CEO of Restricted Stock Partners, the online brokerage's parent company.

In the time since the once-reliable ARS auctions began to fail in February, Silbert has watched his transaction volume double from this eleventh floor command center with its sweeping view of the Statue of Liberty. His traders, as he fondly calls them, are not the high-decibel type. Actually, besides dull admin work, they calmly counsel bruised customers with their encyclopedic knowledge of auction rates. “An auction-rate holder can always pick up the phone and say, ‘You know what, I have this ARS, I offered it at 90 cents and nobody is bidding — what should I do?’” explains Silbert, himself more of a soft-spoken brainiac than a fast-talking trading boss.

Still, some think the ARS panic is overblown. As the estimated $330 billion auction-rate market limps through the summer, one influential brokerage industry analyst exhorts advisors holding big chunks of the frozen securities to chill out. He thinks the market will eventually recover. “Unless you have a liquidity need, now is not the time to sell,” says Brad Hintz of Sanford C. Bernstein. “Retail investors bought these securities as short-term investments, but there is no sign they are going to lose their principal amount.”

Hintz sees the auctions in these markets reviving in another 12 to 18 months. “These are money good,” he says. “We don't have a long history in this country of municipalities going down, with the exception maybe of Orange County.” Nice. (Orange County filed for bankruptcy in 1994 after losing some $1.5 billion in derivatives investments.)

Finding Liquidity

In the meantime, Silbert's is a low-tech substitute for the failed markets. The network is essentially an electronic bulletin board where anonymous buyers and sellers can privately negotiate a price at par. Buyers are eventually found as initial asking prices are gradually lowered from par. The heavy lifting comes later when the actual purchase agreements are signed.

As you have probably heard by now, ARS auctions (theoretically, a kind of Dutch auction) began to fail en masse in February when the big dealers, torpedoed by the credit crisis, stopped supporting them. (UBS said it would buy back $3.5 billion in ARS from its clients once regulatory issues have been worked out.) This opened a door for the secondary market. Until this year, the auctions had rarely failed in their 24 years of existence, and were typically held weekly, monthly or every 35 days to reset interest rates on what were really, in many cases, long-term bonds for municipalities, other tax-exempt groups and student loans. Closed-end mutual funds and corporations were also issuers. Clients still collect interest, but cannot get their money out for lack of buyers.

One rep who has been using Silbert's platform and took a hefty 13-percent discount on $100,000 of a Nicholas Applegate closed-end preferred offering, has no regrets. “We turned a negative situation into as much of a positive situation for our client as we could using RSTN,” says Michael Pirello, a CFP and a former Merrill Lynch rep, who recently switched to Summit Asset Management in Florham Park, N.J. (affiliated with LPL Financial). Despite the big discount, he said his client, who needed cash quickly, was satisfied.

These days, all but the hedge funds and some sophisticated bottom fishers are abandoning the ARS market like the sinking Titanic. The $85 billion ARS market backed by student loans has been hardest hit. Buyers in the secondary market are scarce, so the discounts are correspondingly steep — as steep as 25 percent. One student loan issuer, the Missouri Higher Education Loan Authority, announced plans to buy back debt — $30 million worth of $3.5 billion outstanding. The smaller $20 billion ARS market in CDOs is equally toxic.

On the other hand, the ARS market backed by municipalities has made progress. The municipalities themselves have redeemed more than one-third of the $165 billion of bonds they issued, in part because they incur high penalty rates when auctions fail. Closed-end funds issuers, too, have made strides, buying back the $60 billion of auction-rate preferred stock shares they've supported.

Regulators, meanwhile, recently approved plans that would permit money managers to sell a substitute security with a put feature for distressed auction-rate preferred securities — in effect, aiming to find liquidity for current holders.

As for the potential buyers of money market funds, Silbert says, “We have yet to see any go on the record about their interest other than to say that they will conduct their normal extensive due diligence before buying a new security type like this.”

Not good news for investors. Silbert, however, is not complaining. “We are profitable, growing and investing heavily in staff and technology,” he says.

Silbert's RSTN isn't the only game in town. It is one of several electronic systems trading in the secondary market for various unregistered and illiquid securities. The others are operated by NASDAQ and firms such as MuniCenter (a consortium owned by some of the big investment banks), New York Private Placement Exchange (or NYPPEX), in Greenwich, BondDesk Group in Mill Valley, Calif., and Tradeweb in Jersey City. But Silbert's RSTN, investment pros say, has the lion's share of ARS activity, as other systems have either been slow to adapt to it, or have avoided the ARS market entirely.

Advisors at the big investment banks — including Goldman Sachs, UBS and Merrill Lynch — are still feeling the heat from furious clients who say ARSs were sold to them as if they were safe, money-market-like instruments that offered easy liquidity — and a few extra basis points in yield. Some advisors say that's how they were taught to describe ARSs. Dozens of proposed class action lawsuits, and several hundred arbitration claims have been filed, or are currently pending.

One advisor at UBS, a major issuer, recently called a customer to apologize. “[He] called my client to say he felt terrible,” says attorney Erwin Shustak, who's filed ARS cases for many kinds of clients — from an Indian tribe in California to a newly-divorced man. “Not only was he going to lose his business, and the business of other clients, but he also felt my client was deceived.”

Indeed, emails recently subpoenaed by Massachusetts Secretary William Galvin in a civil suit he's filed against UBS, reveals the hurt felt by advisors. In one email, a UBS rep wrote on Jan 10: “We continue to be frustrated by the lack of information that they [UBS] are providing to us.”

Philip Aidikoff, an attorney at Aidikokk, Uhl & Bakltiari in Beverly Hills, Calif., is representing corporate and retail clients holding several hundred million dollars worth of illiquid auction-rate securities. Aidikoff has picked fights before with reps, but this time his attorney's finger is pointed elsewhere. “I think, frankly, this is a situation where registered reps were also victims,” he says, “because they, in effect, sold these instruments on instructions from their broker/dealers without really understanding what they were selling.”

Laurie McRay, of McRay Money Management in Houston, says that if brokerages want to give investors a break, they should buy back the auction-rate securities at the original par value. McRay went through RSTN, recovering 87 percent on $1.25 million dollars of auction-rate securities for a client.

Brokerage firms, for their part, say they are working with clients frozen out of the ARS market to ease their liquidity needs. Some — including Goldman Sachs — declined to comment on specific allegations and on demands to buy back ARS at their original par value.

Merrill Lynch CEO John Thain recently told reporters that the firm is confident its ARS investors will eventually get the par value: “We are actively working with the issuers of these securities to refinance them, which is the ultimate answer,” he says.

Although firms respond that they always put their clients first, the emails subpoenaed by Galvin reveal how retail customers paid a heavy price after corporate buyers rejected UBS' inventory of ARSs. Joe Gallichio, a managing director in the municipal finance department of UBS, referring to how retail customers were sold ARSs, wrote in a February 21 email: “As a firm we tell people we are client focused. So if the client is always right, then we should fix the problem this product has created in WM [UBS' wealth management unit].”

Via a statement, a spokeswoman for UBS said: “Contrary to the allegations, UBS is committed to serving the best interests of our clients. We continued to support the auction-rate securities market longer than any other firm.”

Pirello, the former Merrill Advisor, says if his approach to RSTN casts him in a poor light, so be it; his client had a pressing requirement. “It would have been worse if my client was not getting the liquidity,” he says now. “That is not a viable alternative.”

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