Beating Down Investors In Auction-Rate Securities

Auction-rate securities are short-term investments which are often pitched as an alternative to cash. Investors look to them as "safe haven" instruments where they can put money and earn a modest interest rate. But, as The New York Times points out "the bonds are, in fact, long-term securities. But the banks hold weekly or monthly auctions to set the interest rates and give holders the option of selling the securities."

Because of the global credit crunch the next tranche of investors is not around to buy these instruments and keep the market liquid. Trading in this market has gotten "locked up" and owners of the auction-rate securities have to figure out how to get their cash back.

MarketWatch writes that "an investor such as a corporate treasurer buys auction-rate securities, often municipal bonds but also sometimes preferred stock or corporate bonds. These have long-term maturities, but act like short-term investments because the holders can sell them at weekly or monthly auctions, when their rates reset."

This is another fine example of how the Einstein-level quants at Wall St. firms were never enlisted to look at the risks in these instruments, or, if they were, the information was not disclosed.

Bear Stearns (BCS) is under scrutiny from The Justice Department for not disclosing risks in its subprime-based hedge funds. It is the same old song. Wall St. firms may have known of the risks of these instruments because their analysts told them. Or, they must have seen the gridlock in the auction-rate market a few weeks before their investors knew. It did not happen in a day.

The bottom line is that the sellers of auction-rate paper had knowledge about the market before the clients did. They weren’t given the chance to get out, even at a loss.

Wall St. now posts another example of its culture which is based on saving your own skin, even if it costs the customer all his money.

Douglas A. McIntyre