Guest Column: Auction-rate securities burn some investors

Wrong. Instead, many local investors, including individuals, cities, counties, schools, retirement plans and other institutional investors with large payrolls and other short-term cash needs, have found themselves in a liquidity crunch.

Many investors were told these investments were as safe and liquid as money markets, certificates of deposit and treasuries – but with substantially greater returns. Instead, many are now holding ARSs with maturity dates beyond 2040.

The potential debacle is huge: approximately $330 billion.

ARSs are long-term bonds of 20 to 40 years issued by various cities, student loan agencies, hospitals and others, but they were recommended as short-term investments that could easily be bought or sold at Dutch auctions which occurred every seven, 28 and 35 days.

Because of the higher interest rate, they were attractive to investors seeking alternatives to very low money-market rates. If your bank or broker is recommending a liquid investment grade or government-backed short-term vehicle that returns 3 percent instead of 1.5 or 1.8 percent, why not?

While the risks were certainly known and recognized by the ARS specialists on Wall Street, the growing risks during the last nine months allegedly were not disclosed by the brokerage houses and banks to the smaller institutional investors, governmental entities and individuals.

It appears that in September or October last year, the largest institutional investors recognized, probably based upon their conversations with their brokers, that the risks were growing substantially.

Wall Street and large banks, losing the support of their largest institutional investors, began marketing ARSs more aggressively to their smaller customers and began propping up the auctions by taking ARSs for their own house accounts.

In February, amazingly, the largest Wall Street firms and the big banks quit supporting the auctions and a very substantial majority of the auctions failed.

Some of the Wall Street firms and the big banks, between September 2007 and February 2008, shed their own house accounts of substantially all of their exposure, leaving exposed their smaller institutional investors, cities, schools and individuals.

As a result, the Missouri Securities Division, along with several other states, has divided their investigation into the big Wall Street firms and the banks. Missouri is investigating A.G. Edwards/Wachovia.

Many ARSs with the higher reset, default or penalty rates may continue to have a market. Others, such as Missouri Higher Education Loan Authority, have reset rates that are very low or even zero.

What is the value of a $100,000 bond that matures in the year 2044 for which no interest is paid? Obviously, very little.

According to Bloomberg, regulators who allowed dealers to retain control of basic information in the market and manipulate prices at auctions even after the Securities and Exchange Commission fined banks in a settlement over bid-rigging two years ago are calling for more disclosure as the failures squeeze borrowers and investors alike.

In some states such as Missouri, ARSs are even illegal investments for certain potential investors and never should have been marketed to them. For example, school districts are evidently not allowed under Missouri law to even own ARSs. Yet they were marketed aggressively as money-market alternatives.

During the first week of May, UBS promised to return $35 million to various Massachusetts governmental entities due to their illegality under state law for such entities.

The firms under investigation include UBS; Stifel, Nicolaus & Co.; Oppenheimer; Scottrade; Smith Barney; Edward Jones; and Wachovia/A.G. Edwards.

Several investors are considering claims against the banks and/or brokerage firms due either to the unsuitability of the recommendation, the illegality of the recommendation or the failure to disclose the volatility of the auctions; the control of the auctions by a small handful of investment houses who monopolized the market; and the outright misrepresentation that they were as liquid as money markets.

Some investors have filed arbitration complaints; other lawyers are bringing class action suits and the state regulator probes are just getting started.

Use extreme caution before investing in ARSs. For those who already have, most states’ securities acts allow for the recovery of attorneys’ fees and interest including Missouri, if the securities act was violated by failing to disclose important facts, recommending them as liquid alternatives to money markets, or recommending them to entities that are not allowed to purchase.

Joseph D. Sheppard III is a Springfield attorney with Carnahan, Evans, Cantwell & Brown PC. He is a member of the Public Investors Arbitration Bar Association and was designated a 2006 Kansas/Missouri Super Lawyer in securities litigation. He can be reached at jsheppard@cecb.com.

Statewide Alert

Secretary of State Robin Carnahan last week ranked auction-rate securities No. 9 in her Top 10 Threats to Missouri investors in 2008. This is what she wrote: “Some dishonestly tout these as being like cash deposits or money market accounts. Investors who transferred their money out of cash deposits or money markets into auction-rate securities are finding that they are unable to access their money when they need it most. Investors in such situations need to contact the Missouri Securities Division to learn about efforts to recoup losses.”[[In-content Ad]]