Auction-Rate Securities: How to Get Unstuck

Auction-Rate Securities: How to Get Unstuck
Illustration by Shout

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.


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.

Instead, he was redirected to the bank's brokerage representative, who offered a higher-yielding alternative: auction-rate securities.

Cohen says he told the rep he was on a fixed disability income and needed access to the money frequently for tuition and other expenses. The rep never explained about the auction process, he says. Cohen has been unable to liquidate the securities since February. In May, he filed an arbitration action with the Financial Industry Regulatory Authority, or FINRA. Justin Gioia, a Wachovia spokesman, says the bank won't discuss individual customers.

Cohen says he never received a prospectus, nor apparently did the vast majority of auction-rate security investors. Securities law requires only that a prospectus be provided when new securities are issued; buying at a periodic auction is technically a secondary market purchase.

Investors say that miscommunications from their brokers are aggravating the problem. Wachovia lent Cohen $11,000 against one of his securities, which were issued in $25,000 chunks, but when the Nuveen fund that issued the securities bought back some shares in April, the bank used the first portion to pay off that $11,000 loan immediately. Cohen was surprised to get only $14,000 in cash and is still stuck for more than $75,000 in his account. A new loan was offered at over 7%, more than double the 3.1% the securities now yield.

Nuveen redeemed about 36% of the fund Cohen is in, but he complains he had only 25% of his holdings unfrozen. A Houston investor who owns about $1 million in auction-rate securities, mainly issued by the Calamos Strategic Total Return Fund, had a better experience, after some confusion. The investor, who declined to be named for privacy reasons, was paid 80% of his holdings after Calamos redeemed 81.5% of the securities the week of May 12. When he first heard about the redemption he was outraged, however, because he says his broker told him he'd get 8% redeemed, not 80%. "Their inability to provide clear information just adds insult to injury," he says.


Calamos and Nuveen say they can't dictate how money is distributed when they conduct partial redemptions. "We can't control that process," says Ken Fincher, Calamos' director of product management. "I'm telling people to make it known to their broker that they want to be redeemed. If you raise your hand, you might be first and foremost."

The actual allocations start with the Depository Trust & Clearing Corp., the industry- owned clearing and settlement giant that maintains lists of all securities holders and doles out the money in a lottery process. Under the DTCC approach, funds are distributed randomly to each firm that has customers who own the securities being redeemed. Then each firm uses its own process for divvying up money between customers.

Many firms say that they are following a process similar to the DTCC, but none will reveal their exact methodology. "Currently, client shares are called as determined by a random and impartial lottery," says Alexander Samuelson, a spokesman for Citigroup's (C) Smith Barney brokerage. Other companies won't say anything. Spokesmen for Merrill Lynch (MER), Bank of America (BOA), and UBS (UBS) all declined to comment on the allocation of funds from redemptions. FINRA issued a notice on Apr. 30 to companies urging them to develop systems that are fair to all investors, according to John M. Gannon, FINRA's senior vice-president for investor education.

The incipient secondary market for auction-rate securities may be another source of frustration. A firm in New York called Restricted Stock Partners, along with Fieldstone Capital Group, a New York brokerage firm, are offering to facilitate sales at discounts ranging from 5% to 20% or more. (Restricted Stock Partners charges sellers a transaction fee of 1% when a trade is completed.) But when John Tierney, a retired lawyer in Jupiter, Fla., asked his Smith Barney broker to check prices so he could sell at either firm, Tierney claims the broker said the firm couldn't trade with them. "I'm very angry, and I'm getting very cynical," he says.

Barry Silbert, president of Restricted Stock Partners, says individuals can bypass brokers and set up accounts with his firm to sell, though they aren't allowed to buy. Smith Barney says that "we do not prevent anyone from selling their securities or otherwise moving them from Citi. We do urge clients to understand the price transparency of any secondary market."

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