When brokerage firms were flush with cash and making lots of money from traditional activities like investment banking, auctions never failed. The dealer simply stepped up and bought the remaining ARS and kept the auction from failing. These days, however, the dealers, like UBS (UBS), Merrill and Morgan Stanley are in dire need of capital themselves, leaving the investor to hold the security, perhaps for the entire duration, or 40 years.

This brings to light several important points. First, you are stuck in the security for possibly a long time, but failed auctions pay investors the "maximum rate" as defined by the prospectus, which on the surface sounds good. But in reality, most of the shares associated with closed end bond funds have a maximum rate of 110% of commercial paper.

Blackrock Muni Insured Floating Rate History

Blackrock Muni Insured Maturity Data

Note the "workout date" of 12/31/49. That is 41.75 years for those counting. And with the commercial paper index plummeting along with Fed Funds, I fully expect commercial paper rates to settle as low as 2%, which would net the ARS holder a whopping 2.2% and no liquidity.

So what is happening? UBS announced on Friday that it'll begin to mark the securities to market (as if there actually were a market). They haven’t yet disclosed their pricing methodology but I have one of my own. If someone asked me to buy this security, I would demand a yield of  10%. After all, I can buy agency preferred stock at 12% tax equivalent yield with loads of liquidity. Where would that bond trade? Yikes: something on the order of 23 cents on the dollar, as my table below shows.

Theoretical Price for a 2.2% ARS

There are actually some examples that are actually worse than this. Some student loan-backed ARS have reset to zero coupons. What would I pay for a forty year security with no yield? Zero.

So brokerage firms are about to feel some heat. Investors, no matter how naive, were sold the ARS with the belief that they actually were cash equivalents. The securities will now be reclassified and written down in price simultaneously. The investor will no doubt sue, and the brokers, who to be frank are barely compensated for placing ARS in the client account, may be rather upset as well as the phones begin to ring off the hook. And this is a huge market—somewhere in the vicinity of $300 billion. When they get written down, expect the class action suits to start flying, right at the folks with no balance sheet.

The greedy are now being penalized. It's now possible that the good, the bad, the not-so-good and the ugly will all get hurt at once. Such is the unwinding of greed. 

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