A Few Thoughts On ARS Buybacks

In my last post I mentioned the huge buybacks of the Auction-Rate Securities (ARSs) by major banks and brokerages. The story here is that that these banks and brokers sold what were liquid securities to retail investors with the promise that the market would remain liquid. As was the case with many financial instruments, when the credit crunch hit, the market for ARSs dried up completely, leaving investors with securities they could not sell.

It is suspected that the financial institutions knew that the markets for these securities could seize up, but that they sold them despite this. Most institutions have neither admitted nor denied any wrongdoing (usually a pretty strong indication that something is amiss), but Merrill has an especially weak case. It has come to light that at Merrill Lynch, a research analyst put together a report which concluded that the market for ARSs would freeze if credit conditions deteriorated, but a fixed income saleswoman got her hands on the report and pressured management to blackball it. Ultimately the saleswoman won the argument and the report was never released. So much for Chinese Walls at Merrill. Everyone knew they didn't exist and this is proof.

Subsequent to the market drying up, the retail investors filed a lawsuit and New York State Prosecutor Mario Cuomo strong armed the banks into a settlement where they would buy back the securities from the investors at par and pay a relatively small fine. Financial institutions (including Citi, JPMorgan, Wachovia and Merrill I believe) have thus far agreed to buy back $50B worth of these securities, with expected realized losses totaling a few billion.

A lot of media attention has been given to this case, focusing on the expected losses and fines to be paid. While these are important issues, there has been little discussion on the adverse effect that this will have on the banks' balance sheets. The banks in question will have to use billions in cash to buy back these securities, which they will probably have to classify as Tier III assets (I am assuming the market does not recover, because who among the banks would be buying these illiquid assets?). This will lower banks' capital adequacy ratios and will have the effect of removing at least $50B in liquidity from already extremely stressed credit markets, which is not good news for the financial institutions.