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Jason Rosenthal
Jason Rosenthal
 
Jose Lopez
Jose Lopez

Understanding the Three Pillars of the Current Financial Crisis

Today’s financial crisis has generated new focal points of corporate concern and litigation. Here is a brief overview of what many consider to be the three pillars of the crisis.

July 13, 2009
by Jason Rosenthal, JD and Jose Lopez, JD

While pundits will continue to speculate for many years what caused the current financial crisis, there are at least three areas that played a leading role. These are auction-rate securities; collateralized debt obligations; and a lack of liquidity. Having a basic understanding of these three pillars will allow CPAs to better guide their clients (and perhaps their own companies) through the tumultuous times this crisis has created.

Auction-Rate Securities

The term “Auction-Rate Securities” (ARS) typically refers to long-term bonds that act like short-term debt. ARS can be either municipal or corporate debt securities or preferred stocks that pay interest at rates set at periodic “auctions.” ARS generally have long-term maturities and in the case of preferred stocks, no maturity date. ARS were first introduced in the 1980s. The market for ARS grew dramatically and the value of ARS in existence before the auction market’s February 2008 collapse was estimated at over $300 billion.

Types of Auction Rate Securities

There are three primary types of ARS: Auction Preferred Shares of closed-end funds (APS); Municipal Auction Rate Certificates (Municipal ARCs); and Student Loan-Backed Auction Rate Certificates (Student Loan ARCs).

APS are equity instruments without a stated maturity that are issued by closed-end funds. APS are collateralized by the assets in that fund and typically receive ratings from the major rating agencies. Interest rates are intended to be set in an auction process, usually with auction cycles of seven or 28 days. They often have a maximum rate, based on a short-term index, above which the interest rate cannot be set in auction.

Municipal ARCs are debt instruments (typically municipal bonds) issued by government entities with a long-term nominal maturity and a floating interest rate that is intended to reset through an auction process. Municipal ARCs receive long-term ratings from the major rating agencies and are often backed by monoline insurance, which guarantees repayment of principal and interest when the issuer defaults.

Student Loan ARCs are long-term debt instruments issued by trusts holding student loans. Interest rates are supposed to be set in an auction process and typically have a maximum rate above which the interest rate cannot be set in an auction. Student Loan ARCs receive long-term ratings from the major rating agencies.

All three types of ARS have maximum or default interest rates in the event of auction failure. Some maximum rates are fixed percentage rates, while others are set pursuant to various formulas.

Collapse of the Auction-Rate Securities Market

The collapse of the ARS market in February 2008 has essentially frozen $300 billion of funds that could be used for, among other things, operating expenses, acquisitions and research and development. Realizing that supply far outpaced demand, brokers stopped supporting the ARS market resulting in massive illiquidity of these securities. The loss of these funds has caused stagnation in corporate America. While the U.S. Securities Exchange Commission (SEC) has negotiated settlement agreements on behalf of many ARS purchasers, many corporate purchasers are now engaged in litigation with major banks regarding their investments, which were supposed to be highly liquid and safe, but due to the collapse of the auction market, are not.

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are security backed by a pool of assets whose value and payments are derived from a portfolio of fixed-income assets. The assets underlying a CDO can be loans, mortgages or bonds (some of the underlying mortgages were subprime — an interrelated cause of the current crisis). CDOs are assigned different risk tranches, whereby “senior” tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

CDOs allowed the securitization of mortgages (and other assets), meaning that the risks relating to individual loans could be transferred to third parties. This in turn permitted banks to move risky loans off their balance sheets. Perhaps the key factor leading to the CDO meltdown is that investment banks were able to combine billions of dollars of poor quality loans (i.e., subprime) with higher quality loans and then market the resulting security under an attractive investment grade (“AAA”) rating. When the lower quality loans began underperforming in 2008, CDOs began collapsing and many buyers soon discovered that the investment grade rating was illusory. The collapse of the CDO market resulted in billions of dollars of losses and led to the bailout of several financial institutions. As with ARS, CDOs have prompted litigation among borrowers, investors and others affected by these securities.

Liquidity Crisis

The foregoing issues, combined with, among others things, decreasing housing prices and defaults on loans (including mortgages, credit cards and others), quickly led to liquidity in the marketplace drying up. The commercial paper market disappeared, as the markets no longer trusted ratings agencies. This risk aversion quickly resulting in a “flight to quality,” in which investors sought risk-free, or at least low-risk, investments. This in part brought treasury bill rates to zero, meaning that investors were willing to forego any interest on their money in exchange for the safety and backing of the federal government — basically the equivalent of investors stockpiling their cash under the government’s mattress. Banks even stopped lending to other banks. As a result, credit became widely unavailable and businesses were forced to close, file bankruptcy or find other ways to reposition themselves and find needed capital. This of course continues today, as businesses seek alternative sources of lending, or try to renegotiate existing loans and lines of credit.

Conclusion

Volumes will be written about the financial crisis, including its causes and effects. While the true scope of the crisis of course does not lend itself to a brief article such as this and while theories abound regarding the many contributing factors, those who understand these primary factors should be able to better steer themselves and their clients through these challenging times.

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Jason M. Rosenthal, JD is a partner with Schopf & Weiss LLP, a national business litigation firm based in Chicago. Jose A. Lopez is also a partner with Schopf & Weiss LLP, a national business litigation firm based in Chicago. The firm is currently pursuing ARS claims on behalf of several major corporations. For more information, you can contact Rosenthal at 312-701-9349 and Lopez at 312-701-9309 or visit sw.com.