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Bigger Than Madoff?

Posted by Larry Doyle on March 30, 2009 7:56 PM |

Each and every time I read a review of the Auction Rate Preferred Securities market, I come away thinking it was one enormous Ponzi scheme. Let’s review the facts as reported from a just published Bloomberg story of a $4.7 BILLION Settlement by Citigroup and Wachovia with California Auction Rate Investors:

States, student-loan agencies and closed-end mutual funds were the primary issuers of the securities, long-term bonds with interest rates set at weekly or monthly auctions.

1. Issuers have long term projects funded by long term loans or preferred shares. Those loans or shares are the underlying collateral in an auction rate preferred transaction. While people investing in a pure Ponzi scheme believed they were investing in a legitimate money manager’s business, investors in ARPS believed they were investing in a money market fund. The key here is MISREPRESENTATION.

The debt, marketed by bankers as cash equivalents, offered investors yields of a quarter-percentage point or more above conventional money-market funds, indexes show.

2. In both a Ponzi scheme and ARPS, the allure of regular liquidity with solid returns draws new money into the game. With a Ponzi scheme, the returns are better than a benchmark index. With ARPS, the returns were better than other cash alternatives or money market funds. 

When the market flourished, borrowers paid dealers on average quarter-percentage point a year of the par value of the debt to run the auctions, generating about $825 million annually based on the amount of sales. Citigroup increased the commission its financial advisers earned selling the bonds to investors as the market stalled.

3. In a Ponzi scheme and ARPS, new money is attracted by marketers or salesmen. In the Ponzi scheme, marketers or salesmen could work directly or indirectly for the manager. With ARPS, similarly the marketers or salesmen could work for the primary underwriter or within a selling group. It is likely that many of the marketers and salesmen were not aware of the very nature of the true essence of the scheme.

4. In successful Ponzi schemes, a la Madoff, and ARPS, the regulators who are supposed to protect investors are hoodwinked. It is not a reach to say that the regulators, the SEC and FINRA, were so close to the perpetrators as to be oblivious to the scheme. In fact with ARPS, the regulator FINRA was an investor. 

The market unraveled when banks that supported auctions of the securities for two decades with their own money as buyers of last resort pulled back to preserve capital amid the mortgage market collapse that has led to $1.3 trillion of credit losses and writedowns worldwide.

5. The Ponzi scheme and ARPS both crashed when new money did not continue to come in to support the effort. The manager of the Ponzi scheme can continue to carry out the fraud for a period of time until his own capital is depleted. Similarly, ARPS continued to operate for a short period while Wall Street banks supported the regular auctions with their own capital. After a short period, the banks backed away and the auctions failed.

One may say that ARPS were legitimized because the auction process ran for close to two decades. I would respond that the Madoff scam supposedly ran for longer than that.

Madoff’s final supposed market value of funds brought in was $64 billion. The ARPS market was a $300+ billion market. Some investors have been made whole, but there are still tens of billions if not a hundred billion dollars of investor funds that have not been repaid. State attorneys general have pressured issuers and underwriters to repay investors. The securities regulators have been less helpful. For regular readers at Sense on Cents, I have highlighted the fact that FINRA, at one time, owned $647 million ARPS. 

Many investors whose funds are in those billions still outstanding wonder if their money will ever be repaid. 


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