Auction-Rate Securities: Just How Safe Is This “Safe” Investment?

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Friday, February 29, 2008: Issue #769

“Past performance is no guarantee of future results.” Virtually every prospectus-sold investment product carries this caveat. But how many of us listen?



Not James B. Stewart at Smart Money magazine, apparently.

In a Wall Street Journal column last week, he admits stumbling into an investment tied to a once-obscure type of bond that is now sending shock waves through U.S. financial markets - auction-rate securities.

Auction-rate securities are an unusual type of long-term bond that behaves like a short-term bond. They are routinely used to fund everything from college student loan programs to municipal projects like roads, bridges and airports.

There are hundreds of billions of dollars worth of them outstanding. And, for years, Wall Street has sold them as a safe, liquid, higher-yielding alternative to money market funds. But it hasn’t worked out that way lately. Just ask Brian and Basil Maher…

A Market With No Liquidity

Last July, the Mahers sold their family’s shipping business for more than $1 billion. They handed the money over to Lehman Brothers with strict instructions to invest it only in conservative, cash-like investments. Within a matter of weeks, however, they lost access to more than a quarter billion dollars.

What happened? Their broker put the entire amount in auction-rate securities. And then they bombed.

Liquidity is provided on these securities - and interest rates are set - through regular weekly auctions. But lately, many of them have failed. That means there were no buyers of the securities at rates that were acceptable to the sellers.

(Last month, for example, New York’s Port Authority saw the interest rate on some of its debt jump to 20% from 4.2%, not because of any change in its creditworthiness, but because of disruptions in the auction markets.)

No Market For Auction-Rate Securities

For many holders of auction-rate securities, there is essentially no market right now. That means sellers are frozen, unable to liquidate. And that is causing a lot of unhappiness.

As The Wall Street Journal wrote recently, “the subprime-mortgage crisis that began with America’s most financially strapped borrowers is climbing to the top of the wealth ladder, reaching into the pockets of America’s millionaires.”

The Mahers are taking legal action against Lehman for mismanaging their money. Smart Money’s Mr. Stewart doesn’t seem to know what to do with his broker, Merrill Lynch, just yet. He points out that mutual fund companies that experienced losses in their money market funds that would have “broken the buck” - caused the share price to fall below $1 - have stepped up in the past and made shareholders whole.

He asked his broker if Merrill Lynch was planning to do the same for the shareholders of its auction-rate funds. And he received a straightforward answer. “No.”

Merrill Lynch and several other major wire houses, in fact, have stopped making a market in these securities. That’s one reason the auction-rate securities are failing.

Stewart complains that, “In my view, any failure of the big banks to honor what is at least a moral commitment to the people to whom they sold these shares is appalling.” I agree. Of course, investors also have a responsibility to understand what they’re buying. This is especially true of prospectus-sold items, which generally contain a disclaimer saying, “Oral representations cannot be relied upon.”

Unfortunately, Wall Street generally has a highly prejudiced view of verbal commitments. If you’re giving your broker an order over the phone, for example, that’s a sacred contract. If, on the other hand, your broker tells you the investment he’s selling you is as safe as cash, that’s just an oral representation. Funny how that works, isn’t it?

A Better Choice Than Auction-Rate Securities…

In short, go with what you know. Money market funds are a conservative choice. But they are not risk-free securities. Auction-rate securities? Don’t touch them with a barge pole right now. Understand that any security that pays a higher rate always does so for a reason. And that reason is related to risk.

Most money markets are fine. But if you want to make sure your cash is as safe as it gets, invest it in Treasury securities. Or in a Treasury money market.

The Vanguard Federal Money Market Fund (VMFXX) is one the nation’s highest yielding. For more information, just visit www.Vanguard.com or call 877-662-7447.

Good investing,

Alex

Today’s Investment U Crib Sheet

• Auction bonds were created in 1984. And, until now, they’ve worked. According to Reuters, “auction-rate securities are currently failing at the pace of $15 billion to $25 billion per day.”
• When an auction “fails,” the interest rate switches back to a level stated in the bond documents. It can also be pegged to various money market benchmarks. Of course, holders of the bonds (investors like the Mahers) are stuck with them until a later auction attracts enough demand.But the Mahers may soon have a new way to sell their securities…

• An electronic trading platform, Restricted Securities Trading Network, said earlier this week that it would be making a ’secondary’ market for auction-rate securities. Trading will begin March 3rd.The company is one of the largest online marketplaces for illiquid securities - warrants, convertibles, private, etc. Nevertheless, if you have to sell your “safe” investments in a secondary market, it’s even “safer” to just plain avoid them.

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