Auction Rate Ugliness Returns

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I can't make peace with the recent news that Citigroup (NYSE: C  ) , Merrill Lynch (NYSE: MER  ) , and UBS (NYSE: UBS  ) will repurchase a combined $44 billion worth of so-called auction rate securities from clients caught in the middle of the credit crunch.

Perhaps I can't quite muster sympathy for these folks because I wasn't hit by the allegedly deceptive sales practices of which the banks are accused. Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Goldman Sachs (NYSE: GS  ) , among others, have also been hit with criticism, although they haven't yet settled with clients. Still, the whole thing kind of upsets me.

Trust me …
Long story short, auction rate securities are essentially long-term debt products whose interest rate is reset every handful of days at an auction. As the credit market seized up earlier this year, the auctions fueling these products disappeared, leaving clients who tried to redeem their "cash equivalents" high and dry. It wasn't that the products were necessarily worthless -- just that the auctions that determined their value simply vanished.

In order to quell clients and regulators who've called foul, the three banks mentioned have agreed to make their clients whole, essentially buying back the products they sold them.

First, the lawsuits against the banks claim the products were sold as "just like cash." Whether or not the brokers were truly being deceptive, I have a hard time understating how someone investing into a product with the word "auction" in it could honestly believe there wasn't market risk involved. Second, the products provided superior returns to cash. You don't need a tremendous amount of investment knowledge to realize fixed-rate products with superior returns invariably come with superior risk. It's the same reason junk bonds have higher yields than treasury securities.

Auction rate securities -- among who-knows-how-many other leveraged investment products -- are in the middle of an unprecedented credit crunch. Investors, even when claiming to be misled, have to accept a certain degree of responsibility for their investments, especially when those investments are caught up in a once-in-a-century storm. Swarms of homebuyers got suckered into mortgage products their brokers passed off as safe, only to quickly learn otherwise. They're hardly getting a break, nor should they. That's how risk-taking works.

Lambasting banks for selling products that fizzled opens up a whole new can of worms. If a lawsuit follows every case of investors not getting what they wanted, you'll get the opposite of the moral hazard effect: Brokers may shy away from advising responsible risks, for fear of being called out.

Further completely honest Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On August 12, 2008, at 2:43 PM, ARSVictim wrote:

    I could understand something with the name "auction" having risk. However, I was never told I was buying "ARS" or Auctions" bonds. I was told I was purchasing "28 day paper". Many other safety seeking investors were told names such as "7 day CD, "28 day money market" or "super checking". I don't see how the sightly higher returns than other safe investments equates to the enormous risk foisted on retail investors. Is fraud irrevelant? What about the fact that the banks were selling products knowlingly, with close to zero lliquidity as 100% "AAA" safe. I opened my account and purchased ARS less than a week before the collapse. Was that a suitable investment for my life savings?

  • Report this Comment On August 12, 2008, at 2:58 PM, SharonPierce wrote:

    I have a financial background but am not educated in all financial investments. I understand bonds and stocks and mutual funds, but when our ML investment advisor recommended "7 day paper" I thought he was talking about treasury bills or something like that. Never once did he use the term "auction backed security". He did tell us we needed to give him 7 days notice to access our funds. We took our savings out of a money market fund paying a slightly lower rate. And when the auction failed, our advisor didn't tell us. Later he said he didn't tell us because he couldn't do anything about it. True, but my husband and I could have made different monetary decisions in the interim. If the investment firms pushed these investments without full disclosure, they should be held accountable. Apparently, they can afford to redeem securities as they are now offering redemption because they know they will be forced to do so by the courts. One thing I have learned from this experience is that I have to take the time to be more involved and educated than I wanted to be to manage my investments. I was doing that before I engaged an advisor. What happens to others who don't have a financial background and need reliable financial advice from investement advisors? I think the courts are doing the right thing.

  • Report this Comment On August 12, 2008, at 2:59 PM, teraflop wrote:

    If I want a guaranteed fixed return, I buy a CD.

    If I want a higher return with some principal risk, I may buy a Bond.

    If I want 100% zero risk, i.e., a risk-free interest rate, I participate in the retail US Treasury markets. In the case of the latter if I want 4-week liquidity, I can get it. The money automagically pops back in my account at the expiration of the instrument.

    When I buy cars, I look under the hood and maybe checkout some online resources.

    When I buy groceries, I look at the label.

    I realize that those holding or earning large amounts of cash typically don't have the time to investigate each nuance of every investment and that they expect the financial adviser to be adequately trained and compensated to properly advise them, but I should think that anything as seemingly esoteric as ARS during the plunging depths of a worldwide credit crunch should ring alarm bells.

    One should be careful these days, in all matters.

  • Report this Comment On August 12, 2008, at 4:53 PM, ARSSucker wrote:

    It amazes me that all these people who know so much about what is safe and what is not cannot understand that there are many more of us who do not understand investing and depend upon the financial advisors to tell us the truth. There are rule that say they must tell us the truth and they didn't. With ARS, "auction" was only about the interest rate we would get, the principal was safe, guaranteed and insured. Don't you realize that we were preyed upon by these FAs because they were incented with higher than normal fees for themselves and their firms directed them to unload the ARS they were holding that far exceeded what they normally owned? Shame on you for thinking everyone who was suckered in by this scheme should know as much as you. That is why the regulators are slamming these firms. Read some of the emails in the complaints and you can easily see that we were being targeted.

  • Report this Comment On August 12, 2008, at 6:59 PM, RockerKing wrote:

    With reference to the line in this article which reads, "I have a hard time understating how someone investing into a product with the word "auction" in it could honestly believe there wasn't market risk involved." Forgive me for being naive but isn't the word "auction" used to describe the market for treasury notes (Weekly Auction for U.S. Treasuries) which have the full faith backing of the government of the United States? In addition, since the brokers involved in this debacle described the investment as being a cash equivilant, shouldn't the writer of the article have focused on one other word in the ARS mess.....namely, "security". I am begining to realize why the writers on this site call themselves fools!

  • Report this Comment On August 13, 2008, at 1:59 AM, srwm4 wrote:

    A lot of this mess is being caused by municipalities in Massachusetts who got swindled. I have read some of the pitches, and personally know many of the people involved in making the investment decisions for one municipal government, in particular. The problem, really, is that the RFPs we sent out detailed securities in which it was illegal for us to invest. The pitches claimed that these securities were in compliance with the legal guidelines that we were restricted by. They were not. These sales guys were knowingly and willfully breaking the law. I'm all for free-market capitalism, but inducing clients to break the law is reprehensible. These banks are getting exactly what they deserve.

  • Report this Comment On August 13, 2008, at 12:37 PM, cggoldens wrote:

    Here's a completely different perspective:


  • Report this Comment On August 13, 2008, at 4:57 PM, ARPSFraud wrote:

    The only Fool is the Motley Fool. Fraud is just that Fraud. When the Banks, knowing they intended to stop supporting the auctions, instructed their Bank employees to sell the Bank's inventory of ARPS to the unsuspecting safe money market investments, before giving the order to stop buying the excess ARPS at the auctions...that behaviour should be punished. The Bank's knew when they withdrew their their support the auctions would fail and the ARPS would no longer be liquid and yet they continued to sell the ARPS right up until the end.

    I had US Treasury investment and my broker told me the ARPS where equal in all aspects...

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