Today the SEC resolved charges against Citi and UBS alleging that the two firms misled investors about liquidity risks related to auction-rate securities. The $30 billion settlement is the largest in SEC history and restores liquidity to ARS investors at par value of their holdings.
According to the SEC’s release, Citi will offer to purchase ARS at par from all current or former clients that bought them—even if the customer moved accounts—restoring approximately $7 billion in liquidity to Citi customers who invested in the securities. UBS will do the same, restoring $22.7 billion to its customers. Importantly, “eligible” customers at these firms who have already sold their ARS below par will be eligible for reimbursement as well, according to the release. The SEC’s complaints against the two firms stated that between late 2007 and early 2008, both firms misrepresented the liquidity risks inherent in the securities market by comparing them to highly liquid money market funds, and failed to inform clients that their own growing balance sheet constraints may prevent them from supporting future auctions.
The auction rate-securities market—the obscure corner of the bond market that municipalities, student loan organizations and other institutional investors used for raising capital—was a popular cash storage investment vehicle for wealthier investors. That is, before they froze up in early February of this year. (Read Registered Rep.’s May cover story, A False Sense Of Security, for details of the collapse.) The ensuing liquidity crisis not only caused a lot of pain for investors and institutions that relied on the market for short-term liquidity needs, but it also revealed more problems and conflicts of interest in the market’s structure (despite SEC attention to similar issues in 2005 and 2006).
Given the significant losses both of these firms have suffered in the past 12 months, a reasonable question then is how the firms will finance the $30 billion buy-back program. Asked for specifics about how the firm intends to fund this settlement, a Citi spokesperson said, “We’re not providing that detail publicly.” A spokesperson for UBS said the firm will use a “combination of standard financing solutions involving short- and long-term debt financing, as well as more specialized structured solutions such as the auction-preferred tax-exempt solution.” Asked if he thought the firms were capable of this, Frederic Firestone, associated director of the SEC's division of enforcement, said, “We’re confident they are, yes.”
And while the SEC says in the release it “looks forward” to finalizing the settlements-in-principle it has entered into with Bank of America ($5 billion), RBC Capital Markets ($800 million), Merrill Lynch ($7 billion) and Wachovia ($9 billion), these settlements won’t cover the waterfront when it comes to illiquid auction-rate securities. Critics of the settlements cite the fact that the primary focus of the SEC is retail customers, that institutional customers may not be made whole. Indeed, the terms of the Citi/UBS settlements outlined in the release say only that the firms “will use their best efforts to provide liquidity solutions for institutional and other customers,” referring to those other than individual customers.
Barry Silbert, CEO of SecondMarket, a New York-based secondary market for illiquid assets like ARS, says the SEC settlements with the large firms haven’t slowed his brisk trading business. And he thinks he knows why. “There are a large number of auction-rate securities held by customers at dozens of firms not part of these settlements,” says Silbert. Between institutional customers not covered by the settlements and these other investors at smaller firms, Silbert estimates there is over $100 billion of securities that still need to be unstuck.