Auction rate securities, including the auction rate preferred securities that remain frozen and often pay low interest rates capped at low levels, were sold to retail customers (including some investors close to DealBreaker staffers) by retail brokers. A key question in the lawsuits that have been filed against Merrill Lynch and Morgan Stanley, among others, is what the retail brokers told customers about the the securities they sold.
At least at one firm, we know that asset managers were told that they were to regard the securities as “cash equivalents” because the auctions had not failed for decades. Indeed, it seems that some brokers were given a “script” that urged the so sell these as “cash equivalent” or akin to “money market funds” or “highly liquid” securities.
We know this because brokers and others in wealth management groups have told us. But we’d like to see training materials that spell this out. It will be an important indicator about whether the firms themselves were selling the auction rate securities based on misleading marketing or whether, as some firms are already whispering, it was just a few overeager rogue brokers who oversold the auction rate securities. If the retail brokers were provided with misleading sales materials, they should not be blamed.
Merrill Lynch, for instance, seems to admit the auction rate securities were sold as equivalent to money market type securities in some of its documents. “Auction rate securities have generally been issued as either bonds or preferred stock and are designed to serve as ‘money market-type instruments,’” Merrill says in a document describing auction rate securities on its website.
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More than a month after the trouble started, much of the auction rate securities market remains frozen, leaving hundreds of millions of investor dollars locked-up in illiquid securities. No-one has come forward with a solution, and there is little hope that the market will unfreeze anytime soon. Brokers have offered to loan money to clients with frozen money but this has provoked outrage from customers who are being asked to pay a premium by the same brokerages that led them to invest in the frozen securities in the first place. And most brokerages are refusing to do what many customers demand: buy-out the customer positions.
Joe Mysak at Bloomberg reports that the problem stretches much deeper into the investor world than many suspected.

I’m still getting e-mail on this situation. Closed-end- fund, preferred-share holders, at least the ones I’ve heard from, are livid at the fund companies and feel betrayed by their brokers. I find it very odd that the fund companies and the brokerage houses feel that they can alienate this crowd.
Who buys auction-rate securities? It’s not just “the rich.” I’ve heard from self-employed people who thought it was a good, temporary place for their life savings, at least until they decided what else to invest in. I’ve heard from people who sold businesses and put the money there, and from people who inherited some money and did the same.
The amount of money ranges from $50,000 to several million dollars. In each case, the investors say they were advised by their brokers that their money was in a cash equivalent. The investors rarely looked at prospectuses.

He also notes that if the market for these securities ever does come back, we can expect a lot more regulation.

Auction-Market Investors Look to Regulator for Hope [Bloomberg]

Fred Wilson tells the story of how he got out of the auction rate securities he bought almost a year ago: he was fortunate to hold securities with high penalty rates.
“When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates,” he writes.
We still haven’t been able to get a satisfactory explanation as to us why some auction rate securities were issued with very low penalty rates. Doesn’t this undermine the market clearing function that was supposed to guarantee their liquidity? The brokers we asked about this gave a clear and unsatisfying answer: since the auctions hadn’t failed for decades, people just stopped paying attention to the penalty rates.

Our Run-In With Auction Rate Securities – And What It Taught Me About Markets [Seeking Alpha]

It looks like the Wall Street Journal’s James Stewart got caught up in the auction-rated securities trap. And he is not happy about it.

Last year, when some money-market funds turned out to hold some mortgage-backed securities and faced a liquidity crisis, their sponsors stepped in and redeemed the shares at face value. This seemed the only decent course, not to mention a good investment in customer loyalty.
But when I asked a broker at Merrill Lynch if it would do the same for owners of these money-market equivalents, the answer was “no” — not after the multibillion-dollar write-offs Merrill has taken on illiquid assets. Merrill Lynch and the other big banks that sold these shares have stopped making a market in them, which is a major reason the auctions have failed.
Merrill Lynch, when asked for comment, told me: “We are offering our clients loans which can give them liquidity.” It wasn’t yet clear whether these would be interest-free loans, which they certainly should be, in my opinion.

He ends the column by calling for the SEC to investigate. “At least two states are investigating, and I would expect them to be joined by the Securities and Exchange Commission,” he writes. Since we know SEC enforcement lawyers get their tips from newspapers, you can bet someone has opened a file on this. And with Merrill Lynch playing a central role in Stewart’s story, they are probably on the top of the SEC’s list.
Risks of a ‘Safe’ Investment Are Found Out the Hard Way [Wall Street Journal]

When Wall Street withdrew its support for auction-rate securities, many investors discovered their cash is trapped. Their brokers told them their investments in instruments that were marketed as cash-equivalents were suddenly illiquid. Issuers who depended on the securities for financing are being told by their banks that they must refinance, and of course hand over deal fees to the very institutions that allowed the markets to collapse. And now many want to know why the auctions were in such dire condition that the banks decided the cost of supporting them was not longer acceptable.
“How long did they know the auctions were on life support?” one investor with nearly half-a-million dollars in now illiquid auction-rate securities asked DealBreaker.

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When an unprecedented number of auctions for auction-rate securities failed last week, many individual investors and corporations found themselves wondering how they had suddenly become the latest victims of the credit crunch. The immediate answer soon became obvious—the banks who had sold them on the idea that the investment were so liquid that they were the equivalent of cash had stopped using their balance sheets to support the auctions. Without the banks to prop up the auctions by buying the securities, auction failure became widespread and investors were left holding suddenly illiquid securities.
For several months the banks and brokerages had been “stabilizing” the market. Which is to say, the auctions were already on the precipice of failure and were only clearing because of the banks were stepping in to pull them back from the edge. While this kind of market-making activity has long been a feature of the ARS market, with banks soaking up excess inventory to support the auctions, it became much more extreme in recent weeks and perhaps months.
So far the banks have pinned the blame for the broad-based failures on “strains in the credit market” and “illiquidity.” That’s somewhat unsatisfying—it’s become the universal explanation for everything these days. What they haven’t said is that something more happened in the market, a fundamental shift in the demand for auction-rate securities that will not likely reverse itself in the foreseeable future.
Find out why after the jump.

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