Thursday, February 14, 2008

Auction Rate Securities

The auction rate security market has seized up and investors who bought these securities as cash equivalents are discovering that they own securities they don't understand and can't get rid of:

When M. Brian and Basil Maher sold their family's shipping business last July for more than $1 billion, they quickly put the money in a safe place.

Or so they thought.

The two brothers handed much of it to Lehman Brothers Holdings Inc. with marching orders to make only the most conservative, cashlike investments. Within weeks, however, they had lost access to more than a quarter-billion dollars.

"We didn't think we were taking risks," says Brian Maher, 61 years old. "We read about all the troubles in the credit markets and said, 'I'm glad we're not invested in that stuff.' It turns out, we were."

What are auction rate securities? Auction rates are long term bonds with variable interest rates that reset at regular auctions. As such many brokers and investors considered them short term cash equivalents. Unfortunately, these securities have long term maturities and if no one shows up for the auction, holders are left with long term securities.

Why do brokers sell these securities? That's simple; brokers make almost nothing on money market funds; usually only a few basis points. Auction rates allow brokers to increase their income on cash holdings to about 25 basis ponits. In the case cited in this WSJ article, because of the amount of money involved, it is a signficant difference.

I expect to see more cases like this as clients discover that brokers are not acting in their client's interest but rather their own. The Maher's have filed a claim against Lehman:

In their claim, the Mahers are demanding their $286 million back from Lehman, along with interest, and are seeking punitive damages of up to an additional $857 million.

As for what they learned about investing, "It's about trust," says Brian Maher. "We entrusted our money to Lehman believing them to be looking out for our best interests."

The mistake the Maher family made is brilliantly exposed in that last sentence. Brokers are not looking out for your best interests. As a Registered Investment Advisor, I have a fiduciary duty to my clients. Brokers have no such responsibility.

No comments: