DISTORTIONS IN THE
SECURITIES MARKETS
Wayne Klein
Lewis B. Freeman & Partners, Inc.
October 17, 2008
Five Market Distortions that
Impact Investors and the
Economy Today:
Auction-Rate Securities
 Hedge/Pension Fund Trading Practices
 Credit Default Swaps
 Dark Pools
 Synthetic Securities

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1. AUCTION-RATE SECURITIES:
Background
Auction-rate securities (ARS) are longterm bonds and preferred stock whose
interest rates are set by investors in
weekly or monthly auctions.
 Issuers are primarily municipalities, closedend mutual funds, student loan companies,
and corporations.
 Issuers get lower rates on long-term
money; investors earn above moneymarket rates.

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Marketing of ARS:
Originally, ARS had $250,000 minimum;
recently sold to public investors in $25,000
increments.
 $330 billion in ARS outstanding in Jan. 2008.
 Institutions held 80% of ARS at end of 2006,
only 30% at end of 2007.
 Brokerage firms sold ARS to investors
saying they were liquid, safe, short-term, and
equivalent to cash or money-market funds.

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Design of the auction:
Auction is run by BD selected by issuer.
 ARS are auctioned at par (face) value.

◦ The only variable is the interest rate.

Interest rate is determined using a form
of “Dutch” auction: the lowest bids buy
the securities.
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The “Dutch” auction:
Investors submit bids, indicating how many
ARS are wanted – at what interest rate.
 The securities will be sold to the investors
submitting the lowest bids.
 The highest interest rate required to sell
out the ARS is the “clearing rate.”
 All investors who bid the clearing rate or
lower will get ARS at the clearing rate.

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Unwanted outcomes:
If all existing holders submit “hold” bids, it
is an “all-hold” auction. A below-market
interest rate is paid.
 If there are not enough bids to buy all ARS
offered, it is a failed auction. A “penalty”
interest rate (up to 20%) must be paid.
 BDs want to avoid both results. All-hold
auctions harm customers; failed auctions
harm issuers.

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Quiz – Auction example:

Looking at the 4/18/08 auction results for
Presbyterian Hospital (on the next slide):
◦
◦
◦
◦
What is the penalty rate?
What is the all hold-rate?
What is the clearing rate?
Who gets the securities offered for sale?
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Answers:

The penalty rate is 15%.
◦ This gives the hospital (the issuer) strong
incentive to make sure the auction succeeds.

The all-hold rate is 1.582%.
◦ This penalizes the investors if they all hold.

The clearing rate is 2.6%.
◦ The clearing rate was determined by the UBS
customer that bid for the entire issue at 2.6%.

The lowest 7 bidders get all 101 shares bid.
◦ The 8th bidder (here, the issuer) gets 192 shares.
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Collapse of auctions:

On Feb. 13, 2008, all major BDs stopped
financial support of auctions.
◦ 87% of auctions failed.
◦ $300 billion in ARS was frozen.
◦ 60% of auctions have continued to fail since.
Penalty rates were triggered.
 Even successful auctions and fixed-rate
bonds are now paying higher rates.
 Investors cannot get access to their funds.

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(Belatedly) Redeeming ARS:
Municipal bonds with high penalty rates are
redeeming ARS, using new bond money.
 Some mutual fund ARS have been redeemed.
 Investors could borrow from BD or sell in
secondary market (discounts of 5-50%).
 States forced BDs to re-buy ARS in August.

◦ UBS, Morgan Stanley, JP Morgan, Citigroup,
Wachovia, Merrill, Goldman, Deutsch, B of A.
◦ Will repurchase $65 billion in ARS at par.
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Redemption still waits for some:

Mandated ARS repurchase is not complete:
◦ Mutual fund ARS not required to be redeemed;
◦ Holdings by institutions, wealthy not covered;
◦ Purchases through non-auction BDs still open.
Some customers have filed suit/arbitration.
 Criminal charges and investigations:

◦ Credit Suisse RRs charged for lying about ARS.
◦ Inquiry: Did Lehman dump ARS on customers?
◦ Inquiry: Insider trading by UBS official who sold.
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The future look of ARS:
Small investors will cease participating.
 MSRB plans a website with information on
the outcome of ARS auctions.

◦ MSRB predicts a smaller market will survive.

Mutual funds will offer “put option” bonds.
◦ Guarantors (banks) will agree to buy the ARS
from customers if the auction fails.
◦ These will be sold only to institutional buyers.
Some predict ARS market will disappear.
 Rates will be higher.

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2. HEDGE/PENSION FUND
TRADING PRACTICES:
It is a new world! Consider:
 Mutual funds frequently were using
derivatives to boost their returns;
 42% of pension funds had planned significant
increases in hedge fund investments;
 35% of 2006 M&A value was private equity:
◦ 31,825 deals involving $4 trillion in value
◦ $255 billion in going-private transactions.
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Hedge fund influence:

The 8,000 hedge funds existing in early 2008
controlled $1.9 trillion in assets.
◦ 87% of money is in large funds over $1 billion.

Big funds influence business operations:
◦ Icahn’s proxy fight with Yahoo over Microsoft
◦ Battle for board seats at CSX

Hedge funds control more traditional assets:
◦ Largest shareholders of 4 biggest airlines
◦ Control 60% of oil futures.
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What are the concerns?
Unfunded pension liabilities may be
encouraging excessive risk taking.
 A higher failure rate for private buyouts.
 The investment climate and surfeit of hedge
funds invites insider trading, manipulation.
 Speculators, not hedgers, are primary
purchasers of commodity futures contracts.

◦ Much trading is driven by off-exchange swaps.
◦ Exchange trading = $5 trillion, OTC = $9 trillion.
◦ Commodity prices are a speculative bubble.
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Near-term regulatory changes:

CFTC, Congress investigating speculation:
◦ Is institutional trading the cause of price rises?
◦ CFTC now admits high speculator influence.

Financial crisis will result in more regulation:
◦ SEC investigating manipulation by hedge funds.
◦ Hedge fund regulation may be coming.
◦ Regulation of swaps, off-exchange transactions.
Short selling limitations.
 Enron and London loopholes will be closed:

◦ Monitoring of electronic and overseas trading .
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Market-induced changes:

Collapse, consolidation of hedge funds:
◦ Less leverage available as result of credit crisis,
◦ Short-selling prohibition impacted many funds,
◦ Negative returns: some funds down 20%
 Boone Pickens’ funds are down $1 billion for the year.
◦ High withdrawal rate, low inflows of new funds.
 The concern is that an increase in withdrawal
requests will unleash a vicious cycle of funds selling
assets at distressed prices, to cover withdrawals, and
losses on those sales will result in more withdrawals.

Is a commodity bubble collapsing?
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Long-term changes:

Congress may limit swaps, commodity
speculation by hedge/pension funds.
◦ Higher margin rates suggested.
Hedge fund tax rates may increase.
 Shine on hedge funds will disappear:

◦ Warren Buffet bet $1 million that stocks will
beat hedge funds over a 10-year period.
More regulation of the markets is certain,
due to the financial upheaval.
 Will this drive some trading overseas?

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3. CREDIT DEFAULT SWAPS:

Swaps are private agreements that let
investors bet on companies’ financial health.
◦ In exchange for periodic payments, a swap issuer
agrees to pay if a company defaults on its bonds.
◦ Swaps may be written by insurers or BDs.
◦ Uses: subprime debt, bond insurers, companies.

Swap prices are skyrocketing.
◦ CDS for GM, Ford cost $9 M for $10 M bonds.
◦ Risk premiums have quadrupled since April 2007.

Investors use CDS as proxy for stocks.
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CDS impact:

Greenspan had predicted sale of CDS
would spread risk.
◦ Risk actually was magnified as the same buyers
bought most of the CDS, then defaults rose.

Swaps became a $62 trillion market, are
now driving prices in cash bond market.
◦ Market is over the counter, unregulated.

Many analysts think swap market pricing
overstates the risk of losses.
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Concerns:
CDS are used as proxy for stock purchases.
 Trading contributes to massive volatility.

◦ CDS specialists may be gaming the system.

Swap holders often don’t know identity or
creditworthiness of CDS counterparties.
◦ Difficult to properly value a swap when one
does not know if counterparty will perform.

When risks rise, buyers demand collateral.
◦ This precipitates liquidity problems.
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Bear Stearns:
In early March, a run began on Bear Stearns.
 Other BDs worried about Bear’s ability to
perform counterparty obligations, so they
started demanding collateral from Bear.
 Mar. 14: Fed seized Bear, forced sale to JP
Morgan, guaranteeing $29 billion in credit.
 Fed was motivated by counterparty risk –
that Bear’s failure would trigger others.

◦ Vigorous argument about moral hazard.
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Role of CDS in financial meltdown:
Seizure of Fannie & Freddie triggered CDS
default, $1 trillion worth of contracts.
 Lehman was large CDS issuer, won’t pay.

◦ $400 Bn in Lehman CDS on $155 Bn of debt.
CDS prices for Morgan, Goldman spiked.
 AIG was big issuer of CDS ($400 billion):

◦ As prices spiked, AIG put up $14 Bn collateral.
◦ This capital need hastened AIG’s failure.

New standard: “too interconnected” to fail?
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Short-term effects:
Country credit problems: Iceland CDS at 50%
 Higher capital for BDs, become banks, BHCs.
 Bond insurers downgraded, might fail.

◦ Issuers cannot get AAA ratings.

Banks are protecting against default risk.
◦ Some banks tie interest rates to swaps prices.

Participants must settle defaulted CDS.
◦ Confidence problem: will sellers pay debts?
◦ CDS issuers may be unable to buy bonds to settle

Zero-sum game: a winner for every loser.
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Regulatory reaction:

SEC has expanded its insider trading probe
to include CDS: focus is on hedge funds.
◦ CDS prices often swing ahead of corporate news.
NY A.G. is investigating whether short-sellers
spread negative rumors, to profit on CDS
bought at cheaper prices.
 NY insurance department said certain types
of CDS would be regulated as insurance.

◦ Some sellers must become insurance companies.
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Long-term changes:

BDs are eliminating swaps that cancel each
other out – to improve clearance.
◦ In September, volume dropped by $7.4 trillion.

Clearinghouses being formed to trade CDS,
other instruments having counterparty risks.
◦ Clearinghouses would guarantee performance

More CDS terms will be standardized.
◦ Trading may move to exchanges.

CDS are almost certain to be regulated.
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4. DARK POOLS:

Dark pools are private electronic trading
platforms used to anonymously trade
stocks away from the exchanges.
◦ Operated by BDs, exchanges, ECNs.

Used by hedge funds, private equity to
trade large blocks of stock:
◦
◦
◦
◦
Large trades don’t move markets to get filled.
Avoids broker front-running or copycatting.
Hides intentions of buyers and sellers
Faster execution, lower transaction costs.
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How they work:

One pool installs its software on traders’
systems to watch for comparable opposingside orders between firms.
◦ A match pops up for firms with relevant orders.
◦ Price is usually the midpoint of buy-ask spread.
◦ Trades are executed continuously.
Another system aggregates trades for
hourly cross-matching.
 “Gray pools” let traders send indications of
interest to other pool participants.

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How prevalent are they?

Represent 12% of U.S. daily stock trades.
◦ There may be over 100 dark pools.
◦ Top five have over half the volume.
17% of NASDAQ trades are dark orders.
 The volume of block orders traded on
exchanges has dropped dramatically.
 NYSE reported a record 10.27 billion
shares traded Sept. 18:

◦ 1.1 billion shares routed through 3 dark pools.
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Concerns with dark pools:

There are concerns that dark pools:
◦
◦
◦
◦
◦
◦
◦
Siphon liquidity from the markets;
Distort price discovery;
Mask intentions of traders;
Increase fragmentation of markets;
Reduce efficiency of public markets;
Facilitate manipulation, self-dealing;
Increase volatility.
Exchanges are at a competitive disadvantage.
 Pools overstate volumes, to appear “deeper.”

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Recent developments:

Exchanges view dark pools as threats:
◦ Exchanges offer their own dark pools, serve as
portals to route transactions to other pools.

Firms such as Morgan, Goldman, UBS are
granting access to each other’s pools.
◦ While linking improves liquidity and pricing, it
does not increase transparency.

Predators game the pools, learning order
size and intentions, then backing away.
◦ This information could facilitate manipulation.
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Future developments?
Regulators may demand more transparency.
 Harder for BDs to ensure best execution.
 Pools will trade options, derivatives.
 Denial of access to predators/gamers.
 Closure, consolidation of pools.
 Further consolidation among exchanges.
 Big brokerage firms will have advantages.
 Continued growth will raise questions that
dark pool trading may cause systemic risk.

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5. SYNTHETIC SECURITIES:
Synthetic securities are used to profit
from price movements, and influence
conduct – without owning the securities.
 Synthetic securities are most commonly
created by:

◦ Buying options (puts and calls) on the stock;
◦ Engaging in equity swaps.
CDS are ingredients in many synthetics.
 Synthetic securities are used for short
selling, proxy battles, arbitrage, hedging.

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Total Return Equity Swaps (TRS):

Party A (short party) creates TRS swap with
B (long party) based on company X’s stock.
◦ These are privately negotiated OTC agreements.
A
B cash equivalent of:
◦ Dividends paid by X,
◦ Increase in market value of X stock.
B
A cash equivalent of:
◦ Interest payments based on the value of X,
◦ Decrease in market value of X stock.
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Why?

A receives:
◦ Set interest rate, instead of market returns,
◦ Protection against price decreases.

B gets:
◦ All upside benefits of owning stock, except
voting,
◦ Greater leverage because stock is not purchased.
A may buy or borrow stock to hedge risk.
 Both have economic interests in the stock,
but not ownership interests.

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Concerns with equity swaps:
Decoupling of economic interest and voting
interests.
 Distortion of corporate governance:

◦ Hedgers may withhold votes or ask swap buyer.

Manipulation can be done more cheaply.
◦ If no Williams Act filings, TRS holders can:
 Hide their intentions
 Concentrate large positions in hands of short parties.
 Prevent others from bidding up stock.
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TCIF proxy battle with CSX:

Two activist hedge funds amassed large CSX
position, pushed for changes to boost price.
◦ TCIF bought TRS equal to 14% of CSX stock.
◦ Funds told CSX they controlled $800 M in stock.

TCIF began proxy contest. CSX sued, saying
TCIF failed to make Williams Act filing.
◦ TCIF said because swaps are not stock, no duty.
Court: TCIF broke law; proxy still permitted.
 TCIF won four board seats in June.

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Consequences:

Williams Act applies to synthetic securities.
◦ The court called TCIF arguments formalistic, an
apparent effort to defeat purposes of the law.
◦ TCIF still got to vote shares it controlled.

Britain’s FSA increased disclosure duties:
◦ Hedge funds must disclose swap holdings;
◦ Must reveal short positions in rights offerings.

Congress may require disclosure of TRS use.
◦ SEC is being urged to act.

Company bylaws are requiring disclosure.
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Conclusions:

The U.S. securities markets continue to be
dynamic and innovative.
◦ This usually benefits investors and the economy.

Markets innovate faster than regulation.
◦ Regulators should not channel market changes.
◦ Distortions or abuses will occur.

Because Wall Street failed to prevent abuses,
Congress and regulators will intervene.
◦ When our technology outpaces our ability to
regulate, how should regulators react?
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Contact Information:
Wayne Klein
Lewis B. Freeman & Partners, Inc.
_____
3225 Aviation Avenue, Suite 501
Miami, FL 33133
(305) 443-6622
www.lbfglobal.com
_____
299 South Main, Suite 1300
Salt Lake City, UT 84111
(801) 534-4455
(801) 824-9616 (cell)
wklein@lbfglobal.com

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◦ Acts as receiver and trustee,
◦ Performs forensic accounting,
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◦ Manages restructurings and business
workouts,
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