Broker-dealer firms that underwrote, marketed and sold auction-rate securities (ARS) misled investors by not disclosing the increasing risks associated with ARS and their reduced ability to support auctions, according to the testimony of Linda Thomsen, the director of the Securities and Exchange Commission's Division of Enforcement.
Thomsen testified Thursday at the House Financial Services Committee's hearing on problems and potential resolutions to the auction-rate securities market, which froze up in mid-February when investors stopped buying ARS - effectively drying up all the liquidity in the market. ARS had grown into a $330 billion market by early 2008. Until the ARS market froze in mid-February, auction failures were extremely rare and the market was highly liquid.
ARS and Student Loans
The current lack of liquidity in the ARS market and the Asset Backed Securities market combined with recent subsidy cuts has forced more than 130 Federal Family Education Loan Program (FFELP) loan providers to suspend or terminate a portion or all of their services. The freezing of the ARS market has hit nonprofit lenders especially hard because of their reliance on ARS to raise capital.
In her testimony before the committee, Tara E. Payne, vice president of Corporate Communications at the New Hampshire Higher Education Loan Corporation (NHHELCO), explained that thousands of students were forced to find a new, likely more expensive, student loan provider because funds NHHECLO would have used to make loans are frozen in the ARS market.
Payne testified that NHHELCO's once solid financial base had been significantly compromised by UBS Securities, LLC, NHHELCO's "long-standing, trusted" financial advisor and broker-dealer since 1997.
UBS actively encouraged NHHELCO to extend its commitment to student loan bonds, even when UBS knew that the market for these bonds was on the verge of collapse, according to Payne. UBS advised NHHELCO to reset the maximum rate on NHHELCO's taxable bonds to 17% to 18% to ensure liquidity and prevent auctions from failing.
"We know now that this was a 'scheme' to make the securities more attractive to investors and to keep NHHELCO in the Student Loan Auction Rate
Securities market," Payne said.
Additionally, UBS would bid for bonds that went unsold to prevent auctions they ran from failing, but it was actively considering withdrawing its own holdings in the market. At the same time, it was advising NHHELCO to stay in the market. On February 13, 2008, UBS stopped supporting the ARS market and it collapsed, leaving NHHELCO and investors with billions of dollars frozen.
"UBS never disclosed to NHHELCO that the ARS market was at risk of freezing ... or that UBS was preparing to ends its support of the market," Payne said.
On August 14, 2008, the New Hampshire Bureau of Securities Regulation announced that is was taking action against UBS Securities, LLC for fraud and failing in its fiduciary and moral duty to NHHELCO.
.
Fortunately, NHHELCO was able to raise $94 million from community lenders in order to continue making loans. Congress then passed the Ensuring Continued Access to Student Loans Act, which allows the Department of Education to provide liquidity to the market and enabled NHHELCO to continue making loans.
Proposed Solutions
Payne and others testifying before the committee agreed that it is unlikely that the ARS market will recover in the near future, if ever. Payne urged lawmakers to extend ECASLA to ensure students and families will be able to finance higher education.
"In New Hampshire we know that 82 percent of borrowers in repayment believe that the opportunity to go to college would not have been possible without access to student loans," Payne said. "The credit crisis has threatened many families' ability to get a second mortgage or for students to qualify for private education loans without parents as co-signers. As a result, some low- and middle-income families may be running out of college funding options. We understand that some are turning to borrowing from 401k plans and putting tuition on credit cards."
James Preston, president and CEO of the Pennsylvania Higher Education Assistance Agency (PHEAA) also advocated for an extension of ECASLA, but noted that it was only a temporary fix and a longer-term solution is needed.
"Unless Congress and the Administration address the underlying causes of the current liquidity difficulties, there will continue to be instability in the student loan marketplace and participants will continue to cease supporting student loans," Preston said.
Preston and other nonprofit loan providers have been championing a plan to have the Treasury replicate its efforts to rescue Fannie Mae and Freddie Mac for student loan providers. Under this plan, the Treasury would stand in place of the global markets which are unable to supply sufficient capital to student lenders.
A Wide-Spread Problem
NHHELCO's experience is not unique.
Broker-dealer firms that underwrote, marketed and sold ARS used their sales forces, marketing materials, and account statements to misrepresent to their customers that ARS were safe, highly liquid investments that were equivalent to cash or money market funds, according to Thomsen.
"These firms failed to disclose the increasing risks associated with ARS, including their reduced ability to support the auctions," she said. "By engaging in this conduct, those firms violated the Federal securities laws, including the broker-dealer antifraud provisions."
Federal and state law enforcement and securities regulatory officials have helped tens of thousands of investors get billions of dollars of liquidity restored to them. Before the hearing, the Financial Industry Regulatory Authority announced it reached agreements with SunTrust Banks Inc. (STI), Comerica Inc. (CMA), Washington Mutual Inc. (WM) and First Southwest Co. to settle queries about how they marketed and sold auction-rate securities. Finra said the companies have agreed to repurchase auction-rate securities bought by individual investors, charities and small businesses with $10 million or less in their accounts between May 31, 2006, and Feb. 28, 2008. The companies didn't admit or deny wrongdoing.
Causes of the ARS Market Freeze
The ARS market encountered significant problems during early 2008 for several reasons, according to Thomsen.
One factor was the significant increase in the size of the ARS market, which had grown to $330 billion by the time of the freeze. This larger market required the firms to find more and more customers to bid in the auctions.
An additional reason for the market seizure is the rating agencies' downgrades of the monoline insurers (e.g., Ambac Financial Group Inc, and MBIA Inc.), which provided insurance for many ARS to ensure that holders would receive repayment of their principal if the issuer defaulted. These downgrades resulted in the loss of customers willing to invest in ARS.
Another factor that contributed to the freeze is the sub-prime mortgage and credit crisis that unfolded throughout the second half of 2007, which limited the firms' ability to support the auctions with their own capital. In fact, firms stopped supporting the auctions in mid-February 2008, and the entire market froze in a matter of days. The securities became illiquid, leaving tens of thousands of customers unable to sell their ARS holdings.
A complete list of witnesses who testified and their testimony is available online.
Media Coverage
By Haley Chitty
NASFAA Associate Director of Communications
Posted 09/19/08 to www.NASFAA.org. Redistribution to non-NASFAA institutions is prohibited. Please submit Web Site questions or comments to Web@NASFAA.org.
