Nothing Spreads Like Subprime

Even a sleepy investment vehicle where rich people and companies stored extra cash has been infected

Big clients of investment banks have plenty of reasons to feel burned after the Street's credit market capers. But there's a new dispute that's adding stress to the relationships: the unraveling of an obscure financial instrument known as the auction-rate security.

For years it has been a type of boring offering in which companies and wealthy folks safely parked excess cash. That was until banks figured out how to graft them onto subprime debt. Now they've turned toxic, and a host of investors—from a pair of billionaire brothers in New Jersey to drug giant Bristol-Myers Squibb (BMY)—have lost hundreds of millions.

For two decades the debt traded with few hitches. Often it was backed by bundles of mundane assets like local government taxes or student loans, allowing investors to pick up a few extra hundredths of a percentage point of yield. Frequent auctions to set interest rates allowed investors to cash out and gave the illusion of safety. But when housing took off in recent years, investment bankers stuffed the securities with the now-infamous collateralized debt obligations backed by risky mortgages. It worked until August, when fears of all things subprime hit investors. Then some 60 auctions failed as buyers refused to bid on $6 billion of the securities, says Lee Epstein, CEO of Money Market One, a brokerage that manages corporate cash.

"WE WERE DISPLEASED"

Blue-chip companies are among those nursing the deepest wounds. On Jan. 31, Bristol-Myers conceded $275 million of losses. At least a dozen other corporations have been singed, too. PotashCorp (POT) says it is out $26 million and US Airways (LCC) $10 million. And analysts say there are more to come. "Some of it is our own responsibility for not being aware enough of what was in there," says Andrew Bonfield, chief financial officer at Bristol, which has been investing in auction-rate securities for nine years. But "the banks have been very clever at finding ways to package things. We have let them know we were displeased with the way they behaved."

Others burned by auction-rate securities are taking action. Wireless carrier MetroPCS (PCS) sued Merrill Lynch (MER) after $134 million of its cash was locked up in failed auctions. Merrill said it believes it "acted appropriately."

Wealthy investors M. Brian and Basil Maher are demanding their money back. In a claim filed on Jan. 17 with the Financial Industry Regulatory Authority, the two charge that Lehman Brothers (LEH) sank nearly $300 million into auction securities that failed, tying up their money indefinitely. (The money was about a quarter of their proceeds from selling the New Jersey family's 60-year-old marine shipping terminal business.) The Mahers contend that Lehman agreed in writing to keep their funds safe and available for a couple of months while they decided how to deploy the money. "I'm just astounded that they did what they did," says Brian Maher, 61. "I never came across such a thing before in my 40 years in business."

Why would Lehman take a risk with wealthy new clients? Michael S. Kim of Kobre & Kim, the Mahers' lawyer, asserts that Lehman may have wanted the Mahers' money to prop up Lehman-affiliated deals. He also charges that Lehman continued to invest Maher money in the securities even after the credit crunch started. Lehman's response: "We believe we have meritorious defenses."

Meanwhile, at least one investor has been made whole. The City of Springfield, Mass., claimed that Merrill put $14 million of its money into auction securities without its consent. Merrill reviewed the matter and on Jan. 31 said it would refund Springfield's money.

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