Auction-Rate Securities: $333 Billion in Assets Frozen

New York, NYThe latest victim of the credit crisis—Auction Rate Securities—are producing victims of its own: thousands of investors who either assumed, or were told that their investments were as good as cash.

The reality, is that their money is now unavailable to them—akin to going to a bank and expecting to undertake a withdrawal from your savings account only to be told, "no—sorry, but you can't have your money now. And we're not quite sure just when you can have it."

"Meanwhile, you've got tuition bills to pay, or a tax liability. But unfortunately, you might be out of luck. The problem is not with the product, but just how they are tied to the market, and just how they were handled by brokers. Auction-rate securities (ARS) are in actual fact bonds and other similar products, many of them long-term. These are products most often issued by hospitals, schools, and municipalities in order to raise funds for various needs. Such products carry terms that, on the surface, would suggest that your money would be locked up either for the full term of the bond (say, 30 years), or indefinitely if the security was open-ended without a fixed maturity date.

For the latter, your money would only become available through the successful auction of said securities at weekly, or monthly auctions. These auctions served as the cogs that turned the wheel, and a perpetually steaming market meant that banks had no problem selling ARS at regular auctions.

Such opportunity, some might suggest, breeds complacency and false reality. Thus, brokers began skipping the part that said your money is only as good as the capacity for the ARS to be auctioned, so be aware of the risk. Oh, but it's a bull market, auctions are happening all the time, and nobody ever has any problem freeing up their cash parked in an ARS.

But guess what? People all of a sudden started having problems, and it was the credit crisis that did them in. Suddenly, an investment that was widely considered safe, low-risk or no-risk, and as-good-as-cash, was turning out to be anything but.

The first wave of the credit crisis, borne from the sub-prime mortgage meltdown, resulted in the posting of record losses reported by dozens of blue-chip companies, corporations and lenders. Look what happened at Bear Stearns.

Meanwhile, the regular weekly and monthly auctions of ARS continued unabated. But then, everything just stopped. Suddenly, banks weren't buying. Saddled with massive write-downs and strapped for cash, the buyers stayed home. Banks with ARS supply couldn't sell them, and thus refused to buy what it could not sell.

The catch, is that there is no legal responsibility on the part of the banks to buy auction-rate securities. It only works when the securities are traded at auction. However, if that auction doesn't happen, the very benefit of the ARS investment strategy disperses in a puff of smoke, and money is frozen.

The risks of these so-called safe investments were outlined in a compelling article by James B. Stewart in the February 27th issue of the Wall Street Journal. Like many before him and since, Stewart was well-aware that ARS products were sold as liquid, safe, and a "slightly higher-yielding, tax-exempt alternative to money-market funds."

What was not to like?

In Stewart's case, he writes that he invested in shares of a closed-end fund that utilized the proceeds to buy AAA securities, identified by Stewart in his particular portfolio as municipal bonds. His shares were issued by BlackRock, an asset-management firm partially owned by Merrill Lynch.

A month prior, Stewart sold some of his auction-rate preferred shares (ARPS) in order to free up cash to buy stock, taking advantage of the downturn in the market.

But then, he writes, he heard rumblings of exorbitant rates being paid for some tax-exempt entities, primarily due to failed auctions for municipal bonds. Such news was certainly a red flag. However, Stewart writes that he heard nothing from Merrill Lynch, and his account statement reflected his shares at full face value.

However, as news reports continued to reveal an increasing number of failed auctions, Stewart finally contacted his broker and was told the sad news: the auctions had failed as there were no buyers willing to purchase at rates acceptable to the vendors, essentially collapsing the market.

"There is no guarantee the shares can be sold," Stewart writes. "Indeed, it's highly unlikely they can be. What was a ready source of cash is now essentially frozen."

Stewart makes the point that last year, when money-market funds faced a liquidity crisis due to the failure of mortgage-backed securities, sponsors stepped in and redeemed the shares at face value in the intertest of good public relations, and customer loyalty.

Not so this time. Losses, and write-offs have been too steep, and the most charitable response has been to offer loans at preferred rates, to afford customers liquidity.

That's nice.

The upside is that the securities still maintain their AAA rating, and interest is still being paid, even though the market has collapsed and the funds frozen. The optimistic view is that the market will recover in time. In the interim, however, Stewart writes that the failure of the big banks to honor what is described as a moral commitment is appalling, and noted as of February 27th that two States are already investigating. He expected the Securities and Exchange Commission to join in the fray.

In the meantime, many investors now frozen out of their cash report that they were sold a bill of goods by their broker. Many were promised outright that there was no risk whatsoever, and the investment was good as cash. In many cases, no formal prospectus was offered or received.

Little wonder that many investors, in dire need of cash for commitments and now being forced to borrow funds, are looking to the legal profession for help.