The Auction-Rate Thaw Turns to a Flood

• Email
• Share
• Print

The next step in the auction-rate securities freeze-out is going to be the courtroom, and already the thaw is in full swing.

Auction-rate securities were originally marketed as being "as good as cash," but investors -- from big corporations like Palm (Nasdaq: PALM), Bristol-Myers Squibb (NYSE: BMY), and Bed Bath & Beyond (Nasdaq: BBBY) to little guys like my dentist -- found out the hard way that the only thing as good as cash is cash.

An auction-rate security is an investment whose interest rate resets every few weeks through periodic auctions. Until February, the market makers had never failed to find a buyer for these debts, but the dead of winter changed all that. With the credit markets in turmoil, no one wanted to touch this seemingly toxic paper -- and as quick as a flash-freeze, investors holding these securities were locked out of their money as surely as though it were buried three feet beneath the frozen tundra.

A thaw of sorts began last month, when Eaton Vance received regulatory approval to issue a new type of security that would begin to let investors access their money.

Then, last week, a flood of investment banks announced they were settling investigations by federal and state authorities into how they marketed these investments. Merrill Lynch (NYSE: MER) and Citigroup (NYSE: C) agreed to buy back $20 billion of auction-rate bonds from customers and pay a fine for their marketing practices. UBS (NYSE: UBS) agreed to buy back $19 billion by itself.

That's not enough for STMicroelectronics, which contends that Credit Suisse invested its money in auction-rate securities without authorization; ST has filed suit. Biovail did the same back in May, seeking tens of millions in compensatory and punitive damages through arbitration with the SEC.

That might be a little late for companies like Ciena (Nasdaq: CIEN), Palm, and Bristol-Myers, which found profits hurt by the writedowns they had to take on the securities. It also comes too late for my dentist, who died of a heart attack a few weeks ago; at the time, he was dealing with an inability to get to his funds, which he needed to expand his practice.

The thaw is coming for those who can wait it out, but the repercussions will wash over the issuers who touted these investments that were supposedly “as good as cash” but weren't. For investors, let's hope the burned hand learns best -- and that the idea of chasing yield for a few extra points will be put on ice.

Open a cool one and read these related Foolish articles:

• Don't Touch These 3 Huge Value Traps
• Auction-Rate Anxiety
• Finally, Money for Auction-Rate Securities