Last Thursday, the story hit that Maui County was suing Merrill Lynch. The County’s primary complaint is that a $32 million dollar investment in Auction Rate Securities (ARS) was recommended by Merrill when the firm knew those investments were on shaky ground. Buried deep in a February 18 Maui News story was a notation that the State of Hawaii has “almost a billion” dollars in these same investments, or about one-third of its total assets.
Did you just do a double take? If you not, you should have. Although at the federal level a billion dollars doesn’t seem like much, especially lately, at the State level it’s a monstrous number, capable of dramatically affecting our lives for years to come.
This is a very big deal and worth examining further. There appear to be three main questions: How much are the ARS the State and County are holding really worth? Why is the interest the ARS are paying so low now? And finally, how did our state and local government get themselves into this situation in the first place: were they incompetent, misled or unlucky?
Did the State Just Lose a Billion Dollars?
These investments do appear to have some value. Last December—when this story should have taken off—state Budget Director Georgina Kawamura met with legislators at a joint briefing with the House Finance and Senate Ways & Means committees. At that hearing she said the State “would take a $200 million actual cash loss if we sold them now, and income from reinvestment would be less than we are getting.”
The problem is, no one knows what these ARS are worth because there’s no “market” or place to sell them. In the absence of comparative sales, it’s simply not possible to assign them a value. There’s guidance available in a standard called FASB 157 (Financial Accounting Standards Board), but, based on companies that have applied the standard, it’s obvious that it’s not much help. As of May 31, 2008, 402 publicly traded companies had reported holding ARS on their books, and only 185 had written some of them off. One company, IncrediMail, Ltd., wrote off 98 percent, while Warren Buffet’s Berkshire Hathaway didn’t write them down at all. Both were following the same rules, but the range of write-downs shows this provides no guidance at all. IncrediMail is an unknown company, but if they’re right, the state did indeed lose a billion dollars. Fortunately few agree with them.
The Budget Director’s assessment (that the state has lost $175 million) is right in the middle of the pack relative to the write-downs others have taken, which appears reasonable but not conservative. Yet the possibility remains the ARS are worth far less; until a willing buyer is found and a deal consummated, it’s up in the air.
What Happened to That High Interest?
When Maui County made these investments, the interest promised was 1.79 percent. Right now, the County’s reportedly getting $4,041 a month. Simple math shows they’re making less than 10 percent of the promised rate, or a 0.15 percent return on a $32 million investment.
The state Budget Director also shared that if they held their ARS holding to maturity—which was as long as 35 years given the mix—they’d receive 100 percent of their par value back.
Yet when you add a little market knowledge, these two statements don’t make sense. These investments, if held to maturity, are supposed to represent money loaned to students, municipalities, etc. When issued, most notes pay a fixed rate of interest and also have a fixed value (the loan balance). Over time the investor receives that fixed rate of interest and their principal back as the loan amortizes away. So why did the interest rate drop dramatically?
For the answer to this question, we reached out to Brian Thomas, a local money advisor with his own firm who manages tens of millions of dollars for others. He doesn’t know specifically why the County of Maui bonds are paying such a low rate, but he can describe some general principles. These long-term notes normally pay interest at the rate of the last auction, which used to be regularly held. Some of the ARS had a penalty rate that was quite high if the auction failed, which they all did when the market collapsed in February 2008. This forced many of the borrowers to repay the securities to avoid that high rate.
However this penalty rate was not a contractual feature of all ARS. Many, including most of the SLARS (Student Loan Auction Rate Securities) that the County invested in, had no penalty rate, so the borrower had no motivation to repay. How the rate became so much lower than the rate the County bought them at would require an examination of the underlying document for each of the types of SLARS that the County purchased. This might include adjustments for written-off loans during the period, a reset to the current money market rate (currently a small number close to the actual interest), or other provisions of the security not possible to identify without access to them. The County hopefully has examined their holdings and knows why their interest is so low.
In general, Thomas is not a fan of these investments. “Six years ago when I worked for the largest Swiss bank…I talked to the trading desks and our fixed income department while doing research…and no one could explain how they were formed, how the interest rates were parsed,” he says. Despite being told “they were just like cash with little risk as auctions rarely ever fail” he ultimately decided not to invest his clients’ money in them when he couldn’t find any third-party research.
How Did We Get In This Mess?
The market for these products is only about two decades old. The investments themselves and the supporting auctions were created by the largest brokerage firms, and since 1988 those regular auctions have been held generally without incident. However, during the financial crisis in 2008, the liquidity tightened as fewer and fewer buyers came to the market.
Many investors, including companies and municipalities, were caught by surprise when the various ARS markets collapsed almost simultaneously. When the investments were originally purchased, these otherwise long-term securities were being regularly traded at an auction, generally held every seven to 28 days, depending on the ARS and the market maker. Since they were resold regularly they were classified as short-term investments, something required by Hawaii law for both State and County investments.
Unfortunately, when the open market screeched to a halt, it converted these from short-term cash investments into very long-term holdings, as the provisions of the security said if the auction failed (which was expected to happen only occasionally) the borrower wasn’t required to repay immediately. For the borrower, the security was a long-term one by design, the only fluctuation being the rate of interest they would have to pay, which was reset at every auction. In principal, the buyers were expected to be able to sell ARS to other buyers at the periodic auctions, not force repayment from the borrowers.
Knowing this is important to understanding the County’s case against Merrill. At the same time the company—which held the ARS auctions—was aware that the auctions were struggling, its salespeople were telling County officials exactly the opposite: that there was no problem with these investments. The County says it was misled, but Merrill is defending itself by arguing the salespeople and the market makers didn’t talk to one another (and weren’t allowed to).
Thomas has a different take: he doesn’t trust the major brokerage firms at all. “The brokerage firms could have wrapped this up in an orderly fashion,” he says. “Instead of just abandoning the auctions, as they did, they could have stopped buying the market.” He points out that Merrill Lynch sold the investments that ultimately bankrupted Orange County, California, more than a decade ago. “When these guys dupe a Warren Buffet, there was no way Georgina or Kalbert [the state Budget Director and County Finance Director] can be expected to know any better.”
Where Do We Go From Here?
Last year, the SEC intervened and forced the major brokerages that created these investments and held the auctions to repay many of the civilian investors they misled. The settlement also required that they make efforts to settle with municipalities and other investors not included in the settlement by December 31, 2009. This didn’t happen.
Thus the County chose to sue for “access” to its ARS—which means Merrill would have to buy them at par value. Though Merrill will of course fight the case, it appears likely the County will have the same success that the civil litigants had last year, as the facts are identical. The State, on the other hand, doesn’t seem inclined to follow suit, possibly because, as comments from the state Budget Director indicate, the rate of interest the State is getting on its portfolio is more acceptable than the County’s.
In the end, there’s a lot of money in distress that we haven’t heard much about. It appears the County (at least) is on the right track to getting out of this predicament. Whether they—and so many others—will avoid getting caught in the next financial bubble is another matter.