As the crisis for investors trapped in auction-rate securities grinds into its fourth month, a few slivers of hope have emerged. Some issuers are buying back all or part of the securities, which were often sold as a higher-yielding alternative to money funds and certificates of deposit, and cashing out previously stuck investors. A small secondary market has opened for trading, which offers another outlet, at least for investors willing and able to absorb a loss of principal to get at their money. And some brokerage firms are letting customers borrow against their frozen auction-rate securities at relatively favorable terms.
Brokers aren't just helping customers out of the goodness of their hearts, of course. The Securities & Exchange Commission and state securities regulators and attorneys general from 10 states are investigating the $330 billion market. Several hundred arbitration claims are expected to be filed over the new few weeks, and lawyers have filed suits seeking class-action status against 14 Wall Street firms.
Even as the crisis seems to ease slightly, a new round of charges of unfair practices, inadequate disclosure, and securities law violations is emerging. Many small investors complain they're not getting a fair share when issuers refinance a portion of their auction-rate securities. Others say they've been offered loans charging double or triple the rate they're receiving on their securities. And some investors willing to take an immediate loss by selling in the secondary market claim that their brokerage firms won't let them do even that.
Municipalities, closed-end funds, and some state student loan authorities have issued hundreds of billions of dollars worth of the securities, either as shares of preferred stock or as long-term bonds. The twist is that the securities' interest rates are reset by auction, typically on a weekly basis, giving existing holders the chance to sell if they need access to their cash. For years, the auctions ran smoothly, leading many to think of the securities as liquid cash alternatives with a slightly higher yield than money-market funds and certificates of deposit. But the credit crisis scared bidders away and left broker-dealers, who had stepped in as bidders of last resort in the past, without room on their balance sheets to participate. When the auctions began failing in mid-February, investors had no way to sell.
SILENT AUCTIONS
Analysts estimate that individuals hold more than half the market. In theory, an investor should be able to sell at auctions every 7, 28, or 35 days. Since February, though, after rating downgrades to some firms that provided credit support to the securities, few buyers have shown up at most auctions. About half of auctions for municipal securities are failing, and virtually all auctions are failing for securities backed by student loans or issued by closed-end funds, according to Bloomberg News.
While some of the securities, particularly those issued directly by municipalities, pay a penalty rate of 10% or more when an auction fails, others pay much less, especially preferred shares issued by closed-end funds. The high penalties have prompted municipalities to refinance securities more often than other issuers.
Closed-end fund companies, which used proceeds from auctions of preferred shares to leverage their portfolios, face a more complicated task to refinance. Fund managers have a fiduciary duty to serve the interests of ordinary shareholders in their funds as well as the preferred shareholders, so they can't simply arrange higher-cost borrowing. Student loan issuers are also largely stuck, since they can't force college graduate borrowers to pay back the loans that underlie the securities any faster.
Jerry Cohen, 51, ended up owning auction-rate preferred shares issued by closed-end funds of Nuveen Investments in January, 2007.He'd gone to his local Wachovia (WB) bank branch outside Philadelphia to put $150,000 from a home sale into some CDs.