Auction-Rate Securities: Investors Led Down the Garden Path

New York, NYIf the auction-rate securities debacle taught us anything, it is that Grandma was right all along: the safest place for your money is in your mattress. Sure, you don't earn anything from it. But you don't lose it, either—as scores of investors found out the hard way after the sudden and spectacular collapse of the auction-rate securities market this year. Investors lost billions.

And they didn't lose simply their profit, either. They lost the principle, the nest egg, and the whole enchilada. Grandma would have warned them not to gamble in such a way with their money, that investing in something that appeared too good to be true probably was too good to be true, and you only have yourself to blame for being so trusting.

But hold on a minute, Grandma. Can you blame them? Especially in light of the news that has surfaced in the last number of weeks that as many as 85 per cent of the companies that went for a ride in what turned into the doomed auction-rate securities rollercoaster were either led to believe, or were explicitly told that the major banks on Wall Street would serve as a lifeline in the event of a sinking.

According to the findings of a survey published by the Association for Financial Professionals, nearly 70 per cent of corporate treasurers whose organizations held auction-rate securities revealed that dealer support was implied, while 17 per cent were told in no uncertain terms that the investment bank of record would be there to ensure the auctions would not fail.

But fail they did—and this is where Grandma would have leveled her first "I told-you-so..."

The auction-rate securities market was routinely used by both companies as well as individual investors, to park cash in an entity that offered a higher yield than GICs or other vehicles that were more liquid by design, but also afforded lower yields. While the securities themselves were long-term, the regular re-setting of interest rates together with regular buying, and selling of the securities offered investors the means to enjoy a slightly higher yield, while minimizing the risk from an otherwise long-term security with the involvement of the participants.

In other words, looking at the security itself, an investor may not be in a position to cash out until the bond matures. However, if someone offers to buy the bond from you, then Bob's your uncle.

The practice quickly evolved to a $330 billion dollar behemoth, with investors buying and selling long-term bonds like candy.

Of course, it was great so long as there were buyers and sellers in equal measure. And there were—the market was healthy and strong. Nobody waved a red flag, even at the basic premise of an investment strategy which worked according to the goodwill of the market, but in isolation was appearing like a mass end-run around the terms of the very securities bought and sold.

No matter. Everyone was doing it, and all parties played the game like there was no tomorrow. Easy to do, with brokers and their affiliates maintaining their mantra that such investments were 'good as cash.'

And then tomorrow came. People stopped buying, fearful that they could not sell. Vendors couldn't sell to save their lives, as the buyers dried up.

"Organizations based their confidence in the liquidity of the instruments on the belief that dealers would support the markets regardless of market conditions," stated an excerpt from the survey by the Association for Financial Professionals.

What's more, many top companies "believed, incorrectly, that dealers would support the auctions if bidders failed to materialize." The survey was based on 342 respondents, of which about 30 per cent invested in auction-rate securities at some point in the past four years.

The market began to fail in February as banks withdrew support from the sector. Within weeks the multi-billion dollar market had imploded and collapsed, leaving scores of investors holding long-term debt that was supposed to have been short-term. Many depending on that debt being short-term were seriously hurt financially. Others have launched lawsuits against brokers, and their parent companies, for leading them down the garden path. Still others are dissing their banks after being offered 'attractive' terms for borrowing funds to offset the losses that the banks, allegedly, said that they would cover.
It all does little to help client/lender relations in an economy already rife with uncertainty.

One of the first acts of regulatory response to stem from the probes saw the Massachusetts state securities regulator file civil fraud charges against UBS for allegedly misleading investors about the securities. The Swiss bank denies the allegation.

Meantime, it is clear that Grandma would never have been able to afford the lifestyle that so many enjoy today, thanks in large measure to modern investment strategies. But in the end, the dear woman sleeps the sleep of the just and the righteous, on a mattress stuffed with cash that no broker with a bill of goods would ever succeed in taking away from her.