A key question in the liability of brokerages in the failure of the auctions for auction rate securities is what customers were told about the risks of the products they bought. The brokerages now claim they properly warned customers about the products, and that they never considered them cash or cash equivalent. Most individual brokers we've spoken to off the record say that this is very inaccurate, and every retail customer we've spoken to (including some who are friends and family of DealBreaker editors) say they bought these securities with the understanding that they were "highly liquid" or "cash equivalents."

So what did the brokerages tell retail customers? There were lots of disclosure documents that say a variety of confusing things but almost none of them reveal the risk of systemic and perhaps permanent auction failures for the auction rate preferred securities that pay low interest rates even after auction failure. And, as the screen shot of a ARPS customer online account above reveals, the brokerages did, in fact, take actions that encouraged customers to regard the ARPS as cash. This account comes from a Merrill Lynch customer account. (Click on image for a bigger version.)

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.

Send any information or sales materials you have to tips@dealbreaker.com. Your anonymity will be protected.

A class action lawsuit was filed in federal court yesterday against Merrill Lynch, hours after we reported that Merrill had been threatened with suits by brokerage customers whose assets were frozen in auction rate securities. Merrill is the latest entrant in a club that includes Morgan Stanley, Deutsche Bank and UBS, all of whom have been separately sued over alleged deceptive marketing of auction-rate securities.

Merrill also faces a separate arbitration claim from ASTAR Air Cargo, which seeks compensatory damages of $9.125 million and punitive damages of at least $27.375 million. ASTAR, an air carrier based in Wilmington,Ohio, filed the claim with the Financial Industry Regulatory Authority to gain access to ASTAR’s funds that currently are frozen in illiquid auction rate securities in the company’s Merrill Lynch account.

According to ASTAR, the air carrier instructed Merrill Lynch to place its cash reserves in products that would provide complete safety of principal and complete liquidity. In response, Merrill Lynch reportedly recommended the company purchase various ARS.

Update: Here's a copy of the complaint against Merrill.

Merrill, Morgan Stanley sued over auction rates [Reuters]
ASTAR alleges Merrill Lynch fraud [Willmington New Journal]

More auction rate securities lawsuits are hitting the courts. A lawsuit was filed today in federal court in Manhattan alleging that Morgan Stanley “deceptively marketed” auction-rate securities as cash alternatives, Market Watch is reporting.

"Instead of disclosing the true nature of ARS and the substantial liquidity risks associated with them, Morgan Stanley continued to push as many ARS as possible onto its customers in order to unload the inventory off its already troubled balance sheet," the lawsuit said.

The complaint seeks to compel Morgan Stanley to refund investor money by having it rescind millions of dollars of ARS transactions. It also seeks compensatory and punitive damages. The lawsuit is being brought as a class-action suit on behalf of thousands of investors who acquired auction-rate securities from Morgan Stanley between March 25, 2003, and Feb. 13, 2008,.

Similar suits have been filed against Deutsche Bank and UBS. Merrill Lynch has also been threatened with lawsuits by investors, although none have been filed. Goldman Sachs has been rumored to have been quietly bailing out some customers, including high ranking Goldman executives, whose assets were frozen when the auction failes.

Morgan Stanley sued over auction-rate securities marketing [Market Watch]

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.

For close to three years the Big Four accounting firms have been advising their corporate clients to change the way they account for auction-rate securities. Many companies changed the way they account for auction-rate securities on their balance sheets, sometimes classifying them as current assets and short-term investments. But some, like Continental, continued to included at least some portion of their auction-rate securities in the “cash equivalent” line.

Early last year the Financial Standards and Accounting Board decided that the “cash equivalent” designation was too open to confusion and abuse and recommended it be eliminated from cash flow statements. Many corporate treasurers and investment banking professionals who spoke to DealBreaker believe that this helped trigger the sell-off of auction-rate securities at the end of last year and the beginning of this year.

Others point to an even more recent accounting phenomenon—an advisory issued in January by Deloitte that warned auditors that “many issuances of auction rate securities have been adversely affected by the turmoil in the credit markets; thus, their current fair value is at a discount, sometimes substantial, from par value.” As auditors began to inform client corporations that they were going to have to record impairments of their auction-rate securities, corporate treasurers decided to unload this new source of credit market damage to balance sheets. Even corporations that had changed the accounting treatment of the auction-rated securities much earlier had not really paid much mind to them.

Deloitte told auditors that “because many entities assumed that these securities were economically equivalent to cash (even if they are not the accounting equivalent of cash), investments may not be on the “radar screen” as companies consider their loss exposures in the current environment.”

Once companies began to appreciate the potential for significant declines in value, they began to jettison their auction-rate securities. Suddenly, demand for these securities vanished from the marketplace, however, and companies seeking to unload them found themselves burdened with suddenly illiquid investments they once considered cash.

Auction Rate Securities Warrant Scrutiny for Impairment [Deliotte]

Earlier this morning we discussed how changes in the way accounting rules treated auction-rate securities helped drive corporate investors out of the market. (For a rousing debate of exactly which accounting changes stamped out demand, click here.) Credit market concerns and the changes in the way auction-rate securities are treated on cash flow statements contributed to the rush out of the securities by bringing additional scrutiny to the once obscure financial instruments. At the end of 2007, many companies made the decision to shift assets out of auction rate securities as these changes were implemented for the new fiscal year.

The Apollo Group owned as much as $365 million in ARS at the end of 2007, according to a recent filing. But by February 19, 2008, all but $107 million of the ARS investments had been liquidated and not reinvested in the ARS market. Apollo says this well-timed exit was part of a plan to intentionally reduce its exposure to the auction rate securities, although they do not reveal what prompted the exit. The timing wasn’t perfect, however, and Apollo found itself unable to liquidate approximately $79 million in ARS due to auction failures.

Despite not completely exiting the ARS market, we'll count Apollo a winner. So who's still holding the securities? After the jump, we reveal two companies trapped by the auction failures.

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.

Like our hangover lifting slowing after our third cup of coffee, it’s too early to say that the crisis in auction-rated securities has passed. But the situation is improving for these once liquid securities that investors discovered were not quite as liquid as they had thought when the investment banks stopped propping-up the auctions for them last week. About half the auctions at some investment banks are resetting now, according to people familiar with the matter.

This is good news for some investors who need liquidity. Unfortunately, not all investors will have access to their money. The auctions that are succeeding are those that have the highest reset rates when they fail and the strongest underlying credit. Investors holding paper with lower reset rates—rates tied to LIBOR often issued by closed end funds—will likely to continue to learn the harsh difference between “cash” and “cash equivalent.” The auctions for these securities continue to fail. As short term LIBOR rates and commercial paper rates have fallen, some investors have seen their rates decline to levels less than 4 times that of those with a fixed yield of 10% or more.

The reset rates, which not many in the market had given much thought to before the auctions began to fail, have turned out to be a crucial factor. These were rarely discussed, even by the brokers and money managers who sold these securities to clients, because the auctions so rarely failed. Hedge funds, foreign capital and banks this week have shown an increased appetite for the auction-rated securities, especially those that have now reset to pay high interest rates. One investment banker indicated that hedge fund interest is up nearly 1000% percent from where it was last week.

The ARS market does appear to be stabilizing, at least a bit, and some market watchers are hopeful this is the beginning of a broader thaw. Issuers of the auction-rated securities have indicated an interest in exercising their call rights to buy back the paper. But many of the issuers, particularly municipalities, are slow moving entities so it could take several weeks to restructure their financing. And with the municipal bond market still in flux due to concerns about the bond insurers, it could take even longer.

Now excuse us while we fetch yet another cup of coffee.

A small a number of ARS auctions were successfully completed today but most are still failing, according to a person familiar with the matter. All of the major financial institutions have decided to stop “stabilizing” the auctions by taking the securities onto their own books, and there is little sign that this policy decision will halt. Citigroup stopped supporting the auctions on Friday. UBS later this week. Many others had already called an end to their auction support policies.

But there is some life in the market for ARS. Hedge funds are starting to buy some of the securities—when the failure has triggered a high interest rate or when they can get them at a discount. Many investors—both individuals and corporations—continue to have large amounts of capital essentially locked up in the ARS.

The market for ARS was about $260 billion, funds that are now illiquid. This massive illiquidity is having ripple effects across various asset classes and financial institutions. If the failures continue, many hedge funds may see redemption requests as investors scramble to get cash. Investors facing capital calls from private equity funds may also need to need to get creative to find liquid resources. Brokers tell DealBreaker that their clients are angered because many of them were lead to believe that the ARS was as good as cash.

Unless you are in private wealth management, the term “auction rate securities” might be new to you. But over in the private wealth group, they’ve been treating these things as if they were cash. Clients were funneled into the bonds and told they were the most liquid investment short of actual cash. But yesterday the bond auctions failed in a dramatic fashion, leaving many investors in illiquid positions.

All that you can read in the Wall Street Journal today. But what the Journal doesn’t explain is that this investor liquidity is already having repercussions in the broader marketplace, including the stock market. Many individual investors would use the proceeds from the auction of their bond holdings to purchase equities. Now that they are locked into the bonds, they are effectively frozen out of the stock market. Brokers have told DealBreaker that many clients simply will not be able to purchase stocks until the market for auction rate securities begins operating again, and they expect this lack of purchasers will have a depressive effect on stock prices.

The situation could deteriorate further. Investors who need liquidity might be forced to sell stock, or refrain from making major purchases—such as homes. So far most of the attention of market watchers has been focused on the direct effects of the auction failures. But if this doesn’t turn around soon, there could be major financial consequences.

Debt Crisis Hits a Dynasty [Wall Street Journal]