Government Payments to Wall Street for Auction-Rate Wreck Climb By Michael Quint Enlarge Image/Details
Sept. 9 (Bloomberg) -- Government officials are letting Wall Street banks pull off what makers of defective cars, computers and condos can't. After the collapse of a product banks created and controlled, they're charging the customers for repairs. The customers include taxpayers from New York to California, as well as not-for-profit institutions such as hospitals and universities. They sold auction-rate bonds, whose interest rates were set in periodic bidding. Since the market for those bonds began to fall apart last year, the issuers have had to pay an extra $2 billion in interest. Now the borrowers are on the hook for possibly billions more in underwriting, legal and other costs for replacing the bonds with less expensive debt, according to data compiled by Bloomberg. Most of the payments are going to the same banks that ran the auctions and are accused by New York Attorney General Andrew Cuomo and states' securities regulators of understating the risks to clients. Investors have been promised $55.3 billion in refunds. Taxpayers aren't getting the same break. ``It's sad that taxpayers are paying the costs,'' said Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board, an industry-controlled group based in Alexandria, Virginia. ``If they knew what was going on, they would be indignant.'' Across the country, public-sector borrowers had $166 billion in auction-rate debt. They have refinanced or made plans to do so for at least $103.7 billion of it, or 62 percent, Bloomberg data show. New York's Costs To exit the securities, New York -- the biggest state issuer of the debt with $4 billion -- has so far spent $138.4 million. That's equal to the annual salaries and benefits for 900 state jobs being eliminated because of a budget crisis, plus the cost of preschool education for 20,000 children. Including the initial costs of selling auction-rate bonds and higher- than-expected interest, the state's total extra expenses will climb to at least $340 million, according to state data compiled by Bloomberg. The state sells bonds to fund prisons, roads, mental-health facilities and economic development projects. Ultimately, the government and nonprofit borrowers may end up paying Wall Street billions of dollars in refinancing fees, depending on how issuers replace the debt. If their costs were to match New York's, the tab would exceed $7 billion, not counting higher interest rates. Four of the banks collecting New York's refinancing fees, Citigroup Inc., UBS AG, Merrill Lynch & Co. and Goldman, Sachs & Co., have settled probes into Wall Street's practice of marketing the bonds as equivalent to cash. $522.5 Million in Fines Those banks and four others, Morgan Stanley, JPMorgan Chase & Co., Wachovia Corp. and Deutsche Bank AG, agreed to pay $522.5 million in fines. They also consented to refund investors stuck with securities they couldn't sell after the banks in February ended a years-old practice of supporting the auctions by bidding for their own accounts. Under the settlements, the bond issuers will be reimbursed ``all refinancing fees'' for those sold after Aug. 1, 2007, when auctions began failing in the corporate market, and replaced after Feb. 11. That covers about 1 percent of the public-sector borrowings, and none of New York's $4 billion. Alex Detrick, a spokesman for Cuomo, declined to explain the limitation. Spokesmen for the banks also declined to comment. Bailout for Banks ``It is unrealistic to expect that investment banks, like any other business, would simply provide their services without compensation,'' State Budget Director Laura Anglin said in an e- mailed statement. As issuers pay the banks to replace their auction-rate bonds, they are also reducing the financial institutions' losses on the securities that state regulators forced them to buy back. New York and others are paying face value for old auction-rate bonds as they are replaced, even though they are worth less. ``It sounds like a bailout for the banks,'' said Michael Granof, a professor of accounting at the University of Texas, Austin. The effect on the banks depends on how the auction-rate bonds are refinanced and how much their value has declined. Jeffrey Rosenberg, a Banc of America Securities LLC analyst in New York, estimated that the $58 billion of remaining municipal auction issues are worth 98 cents on the dollar. That suggests a $1.16 billion loss for banks if they held all the bonds. `Burdens Are Enormous' The costs of replacing the debt are squeezing budgets in a weakening economy. In New York, with a projected deficit next year of $5.4 billion, the collapse of the auction-rate market led to $37.8 million in extra interest from February through July as rates jumped as high as 14.2 percent from about 3.5 percent. New York's costs also include at least $69.7 million of interest payments in future years, above what it expected to pay on the bonds. ``The financial burdens are enormous and will be felt in budgets for years to come,'' said Arthur Levitt, a former chairman of the Securities and Exchange Commission, in a speech Aug. 19 to the National Association of State Treasurers in Rockland, Maine. Issuers are partly to blame, according to Levitt. When bankers presented proposals for auction-rate bonds and associated interest- rate swaps, ``skepticism took a back seat to following an investment fad,'' he said. ``As a result, the tough questions were never asked.'' Auction-Rate Invention Bankers encouraged borrowers to make swap agreements, which were intended to convert fluctuating auction yields into fixed rates lower than the cost of traditional bonds. Those swaps, in which borrowers paid a fixed rate to a bank in exchange for a floating payment, went awry when auction costs rose while other rates fell. Auction-rate bonds were invented more than 20 years ago by Ronald Gallatin, a now-retired Lehman Brothers Holdings Inc. banker. They let companies borrow for as long as 40 years while paying short-term interest rates set by bidders in periodic auctions. The public sector began participating in the market in the late 1990s. >From 2000 through 2007, local governments and operators of hospitals and schools paid banks $650 million to market the bonds, based on Thomson Reuters data. On top of that, banks charged as much as $400 million a year to run the auctions, which they propped up by making bids for their own accounts. `Money-Making Opportunity' In the first two months of 2006, for example, bids submitted by UBS prevented 85 percent of the municipal auctions it ran from failing, according to court documents in a civil suit filed in June by Massachusetts Secretary of State William Galvin on behalf of investors. When investor demand evaporated and the banks reeled from losses on securities tied to subprime mortgages, they quit bidding. In mid- February, the market caved, triggering penalty interest rates as high as 20 percent. Borrowers turned back to Wall Street to refinance the bonds. ``We have a money-making opportunity,'' Seema Mohanty, a former investment banker at Zurich-based UBS and now a consultant in Pelham, New York, wrote in a Feb. 14 e-mail disclosed in the Massachusetts suit. ``They are desperate,'' she said, referring to issuers that wanted to get out of the bonds. Government officials haven't been clamoring for relief or publicly criticizing Wall Street. Anglin, the New York budget director, said the market's failure was ``an almost entirely unexpected event.'' Saving Money A spokesman for New York's Democratic Governor David Paterson, Errol Cockfield, declined to comment on the costs of refinancing auction- rate debt or the terms of Cuomo's settlement, referring questions to the Division of Budget. The budget office's Anglin said, ``We support Attorney General Cuomo's continued efforts to examine'' the auction-rate market. Spokespeople for Assembly Speaker Sheldon Silver, a Democrat from Manhattan, and Senate Majority Leader Dean Skelos, a Republican from Long Island, also declined to comment. In California, Brian Mayhew, chief financial officer of the Bay Area Toll Authority, said he doesn't fault Wall Street. ``My first reaction was to blame the banks for the auction mess, but my second reaction was to remember how we saved money for five years because of those bonds,'' Mayhew said. The toll authority, the operator of seven bridges in and around San Francisco, paid 3.62 percent interest on $507 million in auction-rate bonds before the market broke down, he said. It has saved $100 million since February 2003, even with penalty rates. Now the authority is paying Merrill Lynch and Citigroup, the sellers of its auction-rate bonds, to convert the debt. The new borrowings cost as much as 5.33 percent. Never as Good Mayhew said he didn't switch banks because ``we think they have the best fixed-rate desks.'' ``We need to move on,'' he said. ``I've got bridges to get built.'' For San Diego County, California, unanticipated interest since February has added up to $600,000 a month, said Don Steuer, CFO of the county. It also hired some of the same banks that helped issue its bonds to get rid of them. The county sold $343 million of new taxable fixed-rate bonds last month at yields of up to 6.03 percent to replace auction- rate debt used to fund a pension plan. The old securities' cost had increased to 6.08 percent from 5.30 percent as the market went bust. ``It's never going to be as good as we had it when the auction market was working,'' Steuer said. To contact the reporter on this story: Michael Quint in Albany, New York, at [EMAIL PROTECTED] --~--~---------~--~----~------------~-------~--~----~ Thanks for being part of "PoliticalForum" at Google Groups. 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