Back on August 7th, perhaps in a bid to jump ahead of government officials and do things in a manner that would cost it the least, Merrill Lynch (MER) announced that starting in January 2009 and ending a year later, it would purchase at par, ARS that were purchased from the firm by its retail clients.

New York Attorney General Andrew Cuomo promptly jumped on the firm, claiming that that was not good enough and this week, announced that if Merrill Lynch (MER) did not reach an agreement with his office by Thursday, he would sue the firm on Friday. On Thursday evening August 21st, Merrill Lynch (MER) announced that it had reached such a settlement.

It will now move the starting date of its repurchase of ARS from its retail clients up to October 1, 2008 and a start date of January 2, 2008 from other eligible parties. It will also compensate other clients who between February 13, 2008 and August 21 sold their ARS at a loss, participate in arbitrary hearings for clients who suffered a substantial loss in the ARS holdings, and pay a $125 million fine.

Also announcing settlements on Thursday August 21st, were:

Goldman Sachs (GS), which announced a settlement agreement with the New York Attorney General’s office and the Illinois Securities Department. Under the agreement, the firm will pay a $22.5 million fine and start repurchasing immediately, all ARS that was purchased by Goldman Sach’s (GS) Private Wealth Management clients through February 11, 2008.

Deutsche Bank (DB) will repurchase ARS from its clients and pay a $15 million fine.

 auction rate securities goldman sachs merrill lynch

There’s nothing slated on the economic calendar for today that will move stocks and with the earnings season winding down, the only two noteworthy companies that are reporting earnings, are Lowes (LOW) and Trina Solar (TSL). So the markets will have to look for other drivers.

We expect oil to be a major factor and we are looking for some near term bounce in the price of crude oil, which may results in stocks trading down. Even if oil does end up dramatically lower in the next three to six months, the fact of the matter is, it won’t go down in a straight line. So look for that bounce and look for oil related stocks to move up nicely in the short term, on an up move in crude oil prices.

Some of the oil related stocks that we like based on a very near term bounce in oil prices include Devon Energy (DVN), Chesapeake Energy (CHK), Halliburton (HAL), Apache (APA) and Anadarko Petroleum (APC). With the potential for tropical storm Fay to strengthen before hitting the U.S. we may want to avoid drillers.

Should oil price rally and oil related stocks move up, trades might want to sell those stocks and take profit.

We saw decent gains on Friday, in the share prices of some key retailers such as Kohl’s (KSS), Walmart (WMT), Target (TGT) and J.C. Penney (JCP). These stocks could be in the forefront today, as some of them start to give back those gains.

We will also be looking to see whether the bad news from financial sector companies continues. Last week, we got more announcements from them regarding the ongoing auction-rate securities issue and Merrill Lynch (MER) is now under threat of lawsuit from New York Attorney General, Andrew Cuomo as the AG deems Merrill Lynch’s (MER) settlement offer with its clients is inadequate.

Another chapter might also be written in the auction-rate securities saga. Currently, companies that sold auction-rate securities to their clients are all under fire for those sales as the ARS are very illiquid and those clients can’t get their money out. However, the Wall Street brokerages might now face a double whammy.

They might now also be targeted for their underwriting role which potentially widens their liability to the amounts of ARS they sold to their retail clients, plus, the amount of ARS that they underwrote and passed on to other financial companies who then sold them to their clients. So the saga continues.

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Morgan Stanley (MS) is the latest Wall Street firm to announce that it will buy back aution-rate securities from its “smaller” clients that had purchased them from the investment bank, after being told the ARS were cash equivalents that were very liquid, but are now finding out that they can’t get any money that was put in the ARS back.

Wall Street firms in the last ten days, have all been announcing that they will repurchase these securities, after several states stepped up their investigations of how the ARS were marketed by the firms. UBS (UBS) last week, announced that it will be buying back $19 billion worth of auction-rate securities from its clients.

Morgan Stanley (MS) will start buying back the ARS by September 30, 2008. The firm is offering to buy back at par, all ARS held by individuals, charities and businesses with accounts of $10 million or less, that were bought from Morgan Stanley (MS) before February 13, 2008. Morgan Stanley (MS) is estimating that there are $4.5 billion worth of ARS it will have to repurchase using the above guidelines.

Morgan Stanley (MS) is also offering to make whole, any retail client that bought auction-rate securities before February 12, 2008 from Morgan Stanley (MS), and sold them at a loss.

 auction rate securities

Auction-rate securities [ARS] are debt securities that are issued by corporations, municipalities and closed-end mutual funds through Wall Street brokerage firms. Auction-rate securities pay interest and here is where it gets interesting. Instead of a fixed interest rate that is paid periodically, the interest rate on auction-rate securities are set at auctions that are held, weekly or monthly and the interest on an ARS is paid at the end of every auction for that ARS.

At its peak, the ARS market was worth $340 billion. Today, it has just about completely dried up, another victim of the credit crisis. As mentioned above, the interest rates for ARS are set at auctions. The Wall Street firms that issued these securities used to support the auctions by bidding for some of the securities at the auctions. As the credit crisis deepened and their own situation became more precarious, they needed to be more judicious with their cash and they could no longer support the auctions, dooming the auctions.

Additionally, in March of last year, the Financial Accounting Standards Board which sets financial accounting and reporting standards for U.S. companies, issued a guidance which called for companies to eliminate the heading “Cash Equivalents” from balance sheets and cash-flow statements. With this new rule, companies that used to park their money in ARS stopped doing this, basically eliminating the bulk of the buyers for the securities. With no buyers, there were no more auctions and by February of this year, the ARS market completely collapsed. 

That left holders of these securities nonplussed, as some of them thought they were holding instruments that were as good as cash, or in some cases, some of the holders of the ARS had instructed their brokers to keep their money in cash, and now they could not get access to their money.

Tags: auction rate securities

Already struggling Wall Street firms, which are currently faced with billions in losses as a result of the current credit crisis, now have to contend with and account for a not entirely new problem, auction-rate securities or ARS. Auction rate securities are long term debt issued by corporations and municipalities, with a unique interest rate structure that are or were supposed to be reset every week or month, in auctions. That market which at it’s peak, was a $340 billion market, has evaporated, causing the securities to become illiquid, and leaving the banks that issued them potentially liable for billions.

On Thursday 08/07/08, in a settlement agreement with the New York State Attorney General, the Securities and Exchange Commission, and other state regulatory agencies, Citigroup (C) announced that it will offer to buy back at par, auction-rate securities that are currently not auctioning, from all Citigroup (C) individual investors, small institutions, and charities that bought auction-rate securities from the bank before 02/11/ 2008.

The difference between the par price that Citigroup (C) will pay and the “current” market value of the ARS securities,  is being estimated at $500 million. However, to the extent that the ARS market is now very illiquid, with very little demand for them, as well as the fact that more banks will most likely have to follow Citigroup’s (C) lead, creating a situation where there will be a whole lot more of these auction-rate securities on the banks’ balance sheet that they will want to get rid of but with a paucity of buyers, we will probably see another situation like that of collateralized debt obligations or CDOs that the banks have on the books that they have had to keep marking down and for which Merrill Lynch just set a pricing precedent by selling them for $0.22 per dollar of face value.    

As a result, how much of an actual loss to Citigroup (C) this will cost, depends on how much it will be able to get for them in an actual disposition sale. Furthermore, as specified in the agreement, Citigroup’s purchase seems to cover only small investors that would be considered unsophisticated. However, there are also big corporate clients, some of whom currently hold hundreds of millions of dollars of ARS and they certainly will want their money back as well. Some have already filed suit against other issuing banks.

Thursday evening, in following Citigroup’s (C) lead, Merrill Lynch (MER) also announced that it will start buying back in January 2009, the $30 billion in auction-rate securities that its retail clients hold. 

The ARS situation seems to have come to a head this week, as states such as Massachusetts and New York filed suit against several issuing banks for fraudulently marketing auction-rate securities as being very liquid or same as cash, which as being proven now, they are apparently not. Several other states are considering filing their own lawsuits.

Most of the big money center banks and Wall Street firms are exposed to potential losses from auction-rate securities and these auction-rate securities are obviously the next chapter in the credit crisis story. 

Tags: auction rate securities, citigroup, merrill lynch