Auction-Rate Securities: Not Such a Big Deal

I'm not a big fan of the WSJ's front-page story about trouble in the auction-rate securities market today. It's long - over 2,000 words - which means that most readers won't make it all the way past the jump to the end. But it's only in the last 200 words that things suddenly start making sense and a reader gets to see both sides of the story, which starts off dramatically:

When M. Brian and Basil Maher sold their family's shipping business last July for more than $1 billion, they quickly put the money in a safe place.
Or so they thought.
The two brothers handed much of it to Lehman Brothers Holdings Inc. with marching orders to make only the most conservative, cashlike investments. Within weeks, however, they had lost access to more than a quarter-billion dollars.

I've got my father in town, he's a former investment banker who knows his onions, and the first thing he asked me on reading this is how something as safe as auction-rate securities could have lost 25% of their value. It's a good question, and the answer is: they didn't. Oh, and the Mahers don't just want their money back, either, they want much more than that. Allow me to skip to the end of the story:

If buyers return to the auction-rate-securities market, the Mahers could sell their holdings and come out whole. The companies that issued the securities could also buy them back from the Mahers. In the meantime, the Mahers are collecting interest on the securities of more than 6%...
In their claim, the Mahers are demanding their $286 million back from Lehman, along with interest, and are seeking punitive damages of up to an additional $857 million.

If you want to understand the details of how auction-rate securities work, Accrued Interest has a good primer. But in a nutshell, the Mahers own performing bonds, likely from municipal credits. Remember that these municipal bonds essentially never default - that's the point of Jesse Eisinger's piece in the March issue of Portfolio, saying that municipal bond insurance is a racket. And note too that the Mahers are receiving more than 6% interest on these securities.

But they're so unhappy about owning extremely safe short-term debt that they're asking for more than $850 million in punitive damages.

If the Mahers simply took a deep breath, they'd realise what's going on. Their auction-rate bonds roll over every 28 days or so, but right now there's more supply than demand for those bonds, which means that the auctions reset at the maximum allowable interest rate. The municipalities paying interest on the bonds are not happy about this at all - they're paying much more than their natural cost of funding - and so this situation won't last long: either liquidity will return to the auction-rate securities market, or else the municipalities will call the debt. Either way, the Mahers will get their money back, and lots of interest.

But of course that way they wouldn't get their punitive damages.

Update: Mark Conner provides a lot more detail in the comments. Turns out the Mahers don't have municipal credits, but rather subprime-related credits, which means the chances that the issuer will call the bond are lower than I thought.

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