Would you buy a “XXX” security?
Those securities do exist, providing evidence of the perversion of finance during the credit boom that ended so abruptly in 2007 and 2008.
That perversion was not of the type you might associate with the label XXX. The letters instead refer to the number of a regulation that insurance companies found inconvenient, and wished to get around.
Here are some of the features that make XXX securities memorable:
¶They were based on the assumption, endorsed by the bond rating agencies, that insurance regulators were requiring life insurers to retain too much capital.
¶Therefore, investors could take on a large part of the risk of the insurance with complete safety. That would be only the “excess” part, as calculated by the insurance company
¶The securities were sold as virtually risk-free cash equivalents, enabling the investor to get out, at par, once a month. Supposedly sophisticated investors sank more than $30 billion into them.
¶The securities were explained in complex prospectuses that almost nobody even obtained, let alone read.
¶They were guaranteed by bond insurers, like Ambac, further persuading people there was nothing to worry about.
There was, it turns out, plenty to worry about. Espen Robak, the president of Pluris Valuation Advisors, says some of the securities are trading from 5 to 28 cents on the dollar.
The continued existence of these securities provides a reminder that the auction-rate securities market, which collapsed two years ago, is not going to go away. Low-yielding securities remain on the books of unfortunate investors or the brokerage firms that were forced to buy back the securities from some, but often not all, of their customers. Some of these investments will be around for decades, offering a reminder of a time of financial folly.
To make it even more galling for the investors, the brokerage firms that sold the paper to them get additional payments from the issuer every time there is a failed auction.
Auction-rate securities were supposed to accomplish the magic of allowing borrowers to get long-term money at short-term rates. They accomplished that by holding Dutch auctions, usually every week or month, to set the yields for the next period. There were penalty rates to be imposed if auctions failed, which were supposed to assure that borrowers, if they remained creditworthy, would refinance the debt.
We now know that for months the auctions were becoming harder and harder to complete. The Wall Street firms that had underwritten the securities put in their own bids to prevent failure, while at the same time stepping up marketing of the securities. Finally, in the Valentine’s Week massacre of 2008, virtually all firms stopped supporting auctions. The market collapsed.
Since then, there has been a gradual shrinkage of the market. More than 80 percent of the $165 billion of municipal auction-rate securities have been redeemed, but just a quarter of the $85 billion in student loan paper has been redeemed. The other major market was auction-rate preferred securities, often issued by closed-end mutual funds. About half the $60 billion of those has been retired, according to Pluris figures.
Then there is the toxic part of the market. That includes the XXX debt.
Regulation XXX, as issued by insurance commissioners, required life insurers to use government mortality tables when they calculated how much they needed to keep in reserves. The insurers deemed that unreasonable because they did not insure just anyone. They excluded those who might be greater risks. So they should be able to hold lower reserves than the rules required.
Wall Street came up with a way to lay off the excess risk onto a nonrecourse company. That company would be financed by investors who bought an array of auction-rate securities that reset every month.
Unfortunately for the investors, if too many people died, and the reserves were not really excess, the original insurance company could grab the cash. That protected policyholders, but it made the investments risky.
After the auction-rate market froze, holders of securities began to try to find out what they owned, and what it was worth. That turned out to be difficult.
Most of the holders, Mr. Robak said, “could not produce prospectuses.” It had never occurred to them to get such documentation on what they thought was a cash equivalent investment. So they called the brokers who had sold the securities, and found they did not have them either. Finding them took time.
The prospectuses now provide an incredible and perplexing reading experience.
Take one of the larger issuances, for something called Ballantyne Re, an entity set up in Ireland by Scottish Re to spare it the need to hold those “excess” reserves. A 2006 offering underwritten by Lehman Brothers raised $1.65 billion in nine different classes of securities.
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.
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