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