Wall Street’s brilliant innovators created auction rate securities so they could sell a long-term bond with a short-term interest rate. How did that work out? Great, if you think paying lawyers is a good way to get your investment back.

Auction rate securities are long term bonds with interest rates that reset every one to five weeks at auctions. People ready to liquidate provide securities for the auction. Others come from people who only want to continue to hold ARS if the interest rate is at least a specified minimum. Purchasers bid both for a principal amount of securities and an interest rate. The interest rate is set at the lowest interest rate that will sell all the offered securities. That rate is then applied to the entire issue. ARS are liquid, as long as the auctions are working. Sellers included municipalities, student loan finance authorities, and other tax exempt entities. Investors included corporations and wealthy individuals. There were an estimated $330bn outstanding in 2007. The Chicago Fed explains the size:

One of the keys to the growth of this market was the belief on the part of investors that these instruments were the equivalent of a money market fund.

And why did investors think that? Because their banks and brokers told them so. The market held up pretty well for a long time, partly because many brokers supported it with their own money. In 2007, auctions started failing, though that didn’t stop the brokers from selling. Then in February, 2008, they froze completely.

How’s it working out? Some investors have been helped by settlements reached quickly. For example, Goldman Sachs settled in August, 2008, so its customers were only left hanging six months with their supposedly liquid investments. Others were forced to hold on much longer. TD Ameritrade settled $456mn in late July, 2009.

There are still holdouts. Gretchen Morgenson tells us about Raymond James & Co (RJF). Its customers hold $800mn in ARS, down from $1.9bn in April, 2008, as issuers have redeemed the securities. RJF is being investigated by the SEC, and is defending a class action by investors, but it has no intention of taking any responsibility. A spokesperson tells Morgenson that RJF is in great shape, but its customers can just wait for their money. Good to know their capital position is strong. In its 10-Q for the six months ended 3/31/09, RJF said (p. 35):

If the Company were to consider resolving pending claims, inquiries or investigations by offering to repurchase all or some portion of these ARS from certain clients, it would have to have sufficient regulatory capital and cash or borrowing power to do so, and at present it does not have such capacity.

Of course, there is plenty of money to raise their dividend. Morgenson has more, much more.

Charles Schwab hasn’t settled, and Andrew Cuomo is threatening to sue. Schwab blames investors:

Schwab added that its limited participation in the auction rate securities market was “driven by client demand.” It said some 90 percent of purchases were unsolicited trades.

That will come as a big surprise to David S., quoted on one of a number of web sites devoted to this debacle.

"I purchased [$250,000 worth of] auction rate securities from Schwab & Company after they solicited me in November 2007," David says. "The people who sold me the securities indicated to me that these type of securities, which were Jefferson County Alabama Sewer System Bonds, were insured and equivalent in liquidity to a money market fund.

Jefferson County has been in the news lately: it’s in deep financial trouble, and the bond trustee sued to force the County to raise taxes to pay off the auction rate securities. And the insurers? They’re in trouble too.

Auction rate securities are just another example of the ludicrous innovations brought to you by our financial elites. These great minds want to stay free of regulation so they can bring you more innovations. They’ll be spending your money on lobbyists and Congress to accomplish that goal.



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