The Daily Walk of Shame: Auction Rate Securities

This new Motley Fool series examines things that just aren't right in the world of finance and investing. Here's what's got us riled today. If something's bugging you, too -- and we suspect it is -- go ahead and unload in the comments section below.

A week before Thanksgiving, Wells Fargo (NYSE: WFC  ) served up a turkey to shareholders, alerting them that a $150-million after-tax charge would be coming at the end of the fourth quarter.

The jolt to stockholders was less than the hit taken by Wells Fargo customers, who learned they would finally -- albeit slowly -- get back $1.4 billion in investments that had been frozen by Wells Fargo. The banking giant told customers they would learn about a repayment schedule within 90 days.

This source of consumer anger and shareholder disappointment is auction rate securities (ARS), which many of the country's biggest financial supermarkets, such as Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) , offered until the ARS market collapsed.

Auction rate securities were promoted as being as safe as CDs, with a better yield than CDs or money market funds. Consumers were told they would have easy access to their investments. When the ARS soured in early 2008 and customers wanted their money back, promoters said the accounts were frozen.

That's why attorneys general of several states as well as the North American Securities Administrators Association (NASAA) have been filing complaints and even lawsuits against a who's who of finance.

The Wells Fargo settlement was a product of separate agreements with California and NASAA. The company paid a $1.9 million fine and didn't admit to any allegations against it.

Why you should be indignant
If Motley Fool readers are infuriated over Wall Street bonuses, they should be howling over ARS -- because individual investors, as well as institutional investors, were hurt when financial companies froze their ARS accounts.

By Thanksgiving, marketers of auction rate securities had made settlements to return some $61 billion in frozen funds, according to NASAA. And that money is only from 13 settlements with names like Citigroup, Bank of America, TD AMERITRADE (NYSE: TD  ) , Deutsche Bank (NYSE: DB  ) , JPMorgan Chase (NYSE: JPM  ) , and Wachovia, which was later acquired by Wells Fargo.

"We don't know how much ARS money is still out there," Matt Kitzi, the Missouri Commissioner of Securities, told me in an interview.

Kitzi, who heads a NASAA task force on auction rate securities, said he can't identify a typical investor. However, he noted that "we have ample anecdotal evidence that middle-class, Main Street investors were sold ARS as a liquid, safe investment."

Although ARS started in the early 1980s as an investment for institutional investors who could buy in blocks of $250,000, Kitzi says underwriters and marketers later made ARS more attractive to retail investors, small businesses and charities by reducing the buy-in to as low as $25,000.

According to the Financial Industry Regulatory Authority (FINRA), a typical ARS was either a long-term bond or preferred shares with a cash dividend. Those higher yields were produced during periodic auctions -- every seven, 14, 28, or 35 days -- when the interest rates were reset. The system worked as long as buyers outnumbered sellers at the auctions.

However, when the economy nosedived, the ARS froze in early 2008 because there weren't enough buyers. The auctions failed, and when consumers asked for their funds, they were told their accounts were frozen.

What can you do?
The ARS market has dried up, according to FINRA, except for a "limited largely inactive secondary market where some investors have managed to sell their ARS investments below par."

Investors seeking a better resolution have several choices: File complaints with regulators or financial industry associations or try arbitration through FINRA. The organization says that more than 500 investors have filed claims against ARS promoters.

FINRA enforcement actions have returned more than $1 billion to investors primarily from smaller firms that sold but didn't underwrite the ARS securities. In one settlement, for example, FINRA said several firms used advertising and marketing materials that "did not provide a sound basis for investors to evaluate the benefits and risks" of ARS. Supervision of ARS marketing was inadequate.    

Some issuers and marketers of ARS have tried to help customers until the companies can free up the ARS funds. Wells Fargo, for example, has given customers access to as much as 90% of their ARS investments by offering loans at "advantageous rates" until customers' investments are repaid.

However, even when a company agrees to repurchase ARS, the process can take a long time. Earlier this year, Stifel Financial (NYSE: SF  ) said it would buy back some $180 million in ARS in stages through June 2012.

The ARS saga, which is far from over, illustrates the traditional warning that consumers must keep their caveat emptor detectors at high levels when seeking new investments.

However, just look at a typical consent decree, and you'll see from consumers' complaints that companies' marketing outpaced a complete description of risks. Financial firms were criticized for failing to adequately train and supervise the agents who sold these products.

Maybe auction rate securities don't elicit the poignant outrage that grotesque Wall Street bonuses or a $6,000 shower curtain do, but they don't instill any confidence in financial institutions, either.

Fool contributor Robert Steyer doesn't own shares of any companies cited in this story. The Fool has a disclosure policy.


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