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Blog #6
(August 29th, 2008)
WHO'S BIDDING NOW?
AUCTION RATE SECURITIES UNDER SCRUTINY
By Tom McAllister, CFP™
Auction rate securities, a really good idea turned bad, have been making news lately, and quite a number of big-name Wall Street firms are talking with New York State Attorney General Andrew Cuomo regarding these hybrids.
What are auction rate securities? You're probably familiar with traditional corporate bonds and know that bonds have set interest rates. With auction rate securities, the interest rates were reset at auctions as frequently as once a week. Both institutional investors and individual investors liked to own auction rate securities, and financial planners often recommended auction rate securities to their clients. These bond-like investments offered attractive interest rates without the risk of price decline in case of a rise in future interest rates. There was no safety issue, it seemed, since the securities themselves are investment grade (in fact, almost all have A or better credit ratings). The issuers themselves liked the idea of not locking themselves into paying set interest rates for as long as thirty years. Auction rate securities appeared to serve the needs of everyone involved.
What went wrong? Well, amidst the downturn in the broader credit markets, Wall Street in essence ran out of capital to buy these securities and keep trading going. In February, the market for auction rate securities effectively collapsed. Investors who had thought they were holding very liquid investments, almost like money market funds, found they could not redeem their securities at par.
What's being done about the situation? Regulators have been investigating this collapse in the market to see whether banks knowingly misrepresented the safety of auction rate securities when selling them to investors. Meanwhile, several banks and brokerage firms have agreed to repurchase the securities and to reimburse customers who sold at a loss. To help the banks help their customers, the Federal Reserve Board is allowing banks to borrow whatever funds are needed to stabilize the market.
Chances are, you don't own auction rate securities, but if you do, you'll be hearing from your brokerage firm or bank. So far, the banks and brokerage firms that have come to agreements with the Attorney General or with whom investigations are ongoing include UBS, Citicorp, JPMorgan, Morgan Stanley, Wachovia, and Merrill Lynch.
So, is this your chance for bargain shopping in auction rate securities? As a financial planner who's observed the markets for forty six years, what I think is you can probably find less volatile opportunities out there. (Recently issued preferred stock of the major investment firms might be one strategy to explore.)
Speaking of financial planning, I want to emphasize that all securities involve risk, and that this saga about auction rate securities exemplifies that truth. Even though there was little credit risk with auction rate securities, and even though they were not stock investments, developments in the economy and in the mortgage markets were able to significantly and negatively impact them and expose them to other categories of risk. Even with the best financial planning, you cannot totally avoid risk, though you can mitigate risk through diversifying your investments.
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