A Summer Thaw for Frozen ARPS?

This is welcome news for every fixed-income investor and anyone who depends on healthy credit markets. It's especially good news for the holders of $330 billion in ARPS who thought they'd invested in money-fund equivalents only to discover they were among the victims of the credit crisis that gripped financial markets earlier this year. When the credit markets seized, big brokerage firms and investment banks stopped providing liquidity, the auctions failed, and the securities were essentially frozen in accounts. Many people lost access to their life savings, money they had counted on to fund their retirements, college educations, home purchases and to pay taxes.

Here's what's happening now: Major issuers of ARPS, including industry leader BlackRock (BLK), are in the process of partially redeeming the frozen ARPS by refinancing them with tender option bonds. The issuers are basically packaging and selling the choicest bonds in the underlying portfolios based on credit quality, maturity date, and insurability, among other factors. BlackRock announced it will refinance $1.6 billion of its tax exempt ARPS by the end of July, bringing total redemptions to $2.4 billion, or about 25% of the total issued by BlackRock. How much is being redeemed depends on the particular security. BlackRock said investors will regain access to as much as 42% of the face value and as little as 2% through these tender option bonds. (Investors should check the web sites of the issuers for a detailed breakdown of redemption rates and payment schedules.)

Obviously this is only a first step. But Steven Baffico, a BlackRock director in charge of closed-end funds, told me progress is also being made toward converting the rest of the ARPS into money-market eligible paper. The SEC and Treasury issued rulings last week that should help the process. Some hurdles remain, the chief one being attracting liquidity from the same institutions that walked out on the auctions, but Baffico said he's optimistic. "Progress has been good, measurable, and consistent," he said.

I've been hammering away on this subject both in these columns and in SmartMoney magazine, not just because I'm one of the victims, but because the injustice was so flagrant and so painful to many investors. This was not a case of greed run amok, or of people chasing high yields without regard to the risks. Investors were told by their brokers that these investments were the equivalent of money-market funds, highly liquid and safe. This was reflected in the yields, which were barely higher than the money-market equivalent. No one expected to get rich investing in ARPS. It was just a convenient place to park cash while earning a slightly higher return.

The ARPS that I bought, and all of them with which I'm familiar, were backed by triple-A-rated securities. This was not analogous to the investment products backed by packages of subprime loans: Virtually none of the bonds that made up the underlying portfolios defaulted. The ARPS have continued to pay interest throughout the crisis. Even so, many investors have been shocked to see the value of the ARPS lowered on their brokerage statements. (This depends on the brokerage firm. Mine continue to be reflected at full face value, not that this matters when you can't access the money.)

Lawsuits triggered by the crisis have argued there was inadequate disclosure of risks to investors and that any liability should rest with those who sold the securities. In many cases disclosures were woefully inadequate or nonexistent. But to be honest, full disclosure wouldn't have changed my decision to invest. Though the risk of auction failure existed, no auction had ever failed in the 20-year history of ARPS. It's not rational to plan for something that has never happened.

So why did the auctions fail? As best I can tell, as panic swept the bond markets in the wake of the subprime crisis, all structured debt products were suspect, the sound as well as the shaky. Once one of the big investment banks stopped bidding (reportedly Goldman Sachs (GS)), everyone else stopped committing capital to what threatened to become illiquid securities, further depleting their weakened balance sheets. This in turn became a self-fulfilling prophecy. Once several auctions failed, many ARPS investors wanted their money back. It was the equivalent of a run on the bank. (Under the contractual terms of the securities, the auctions are still held every week, and continue to fail.)

With benefit of hindsight, there was no need to panic. The issuers have kept paying interest. Defaults on the underlying bonds have been negligible. If Goldman and the other banks had continued to bid at the auctions as usual, the crisis would never have arisen. But I concede that no one had the benefit of hindsight when these decisions were made and the entire financial system seemed on the brink of collapse. Much as I would like to blame Goldman, it's hard to argue with the firm's financial results or its overall assessment of risk, given its recent excellent earnings, especially compared with other investment banks. (I continue to be a Goldman shareholder.)

Of course none of us will probably buy another ARPS again, which means that the market is essentially dead. In a sense this is too bad, since ARPS helped provide the liquidity that enabled a wide array of institutions, from schools to hospitals, to fund their operations. I am, of course, delighted that these frozen assets are finally thawing and that thousands of investors are likely to get their money back plus interest. Hundreds of investors wrote me about their plight, and I applaud them for helping keep up the pressure on their brokers, the issuers, the investment banks and in Congress. This we still need to do, until the ARPS crisis is fully resolved.

Also See:

Stewart: The "Other Cash" Crisis

Stewart: The Trouble With Auction Rate Preferred Shares

Stewart: More Assets Frozen at Big Banks