As the Federal Reserve tackles $29 billion worth of foul assets for Bear Stearns, Gretchen Morgenson from The New York Times points out that thousands of small individual investors with cash frozen in the dismal auction-rate securities market are also wondering who will help them out.
Big business get bailouts but long-suffering small investors are finding few satisfactory options. They can hope that the issuer of the auction-rate security will buy it back. Or they can sue the brokers who sold the securities but many investors cannot afford these lawsuits. Consequently, investors sit and wait with their frozen assets.
Created in the 1980s, auction-rate securities are debt obligations of an issuer like a municipality or a closed-end fund and interest rates reset at auctions that occur every week to a month.
These were supposed to be safe and liquid cash alternatives for investors. The auction-rate market worked fine until the beginning of this year when buyers disappeared from the auctions, leaving investors with frozen cash.
A majority of the $330 billion auction-rate securities market consists of debt obligations issued by municipalities and nonprofit institutions and some $65 billion is in preferred shares issued by closed-end funds. But the system of the preferred shares is causing a mess with investors.
Closed-end funds issue auction-rate preferred shares at a certain interest rate and earns a higher percentage on that money through smart stock picking so that increases the yield they pay to their common shareholders. Of course, shareholders of closed-end funds love the higher yield that auction-rate preferred shares provide and the closed-end fund companies have a fiduciary duty to those shareholders.
However, investors of preferred shares, which have no maturity dates, don’t want long-term investments and wants the close-end fund companies to buy back their preferred shares. Here lies the quandary then. If the companies were to get rid of preferred shares, their common shareholders would lose out on the higher yield.
Investors also have another reason to be mad because the penalty interest rates they receive on their holdings when the auctions fail are far lower than the penalty rates (sometimes in double digits) on many municipal auction-rate notes. Many investors of preferred shares are relatively small investors who got into the stocks when the minimum investment fell to $100,000 to $25,000 a few years ago.
Some companies are taking action. Two weeks ago, Nuveen Investments, which has 120 closed-end funds and $15.4 billion of auction-rate preferred shares outstanding, said it was hoping to refinance those shares and allow shareholders to cash out. Eaton Vance also arranged a plan to redeem preferred shares issued by three of its funds.
But other fund companies have done little to ease the plight of their preferred shareholders. The impression given to investors is that the companies are concerned first with their shareholders and are not assuming any responsibility to investors.
Steven J. Klindworth, a small investor in Austin, TX, is taking action into his own hands. Klindworth recently filed an arbitration claim against Deutsche Bank Alex. Brown, the firm that sold him the preferred securities, after the firm refused to buy the securities back. The suit says that by putting Klindworth’s assets into the risky securities, his broker had acted contrary to his instructions. According to a transcript of a phone conversation between Klindworth and his broker, his broker said “Had I known those risks, I wouldn’t have put you into it.”
Investors in these preferred securities relied on their brokers’ assurances that the stocks were safe because prospectuses spelling out the risks did not accompany these sales. Since there was no prospectus, the broker had full duty to ensure the investment and risk was suitable to the investor. Brokerage firms made more on these securities than they would have made in selling money market funds.
Regulators are also responding. On March 29th, Massachusetts subpoenaed to UBS, Merrill Lynch and Bank of America seeking documents related to their sales of auction-rate securities to determine whether investors were properly informed of the risks. But on that same day, UBS confirmed that it was lowering the value of its clients’ auction-rate preferred shares by about 3 percent and some may be more than 20 percent.
More lawsuits are expected in the near future if the auctions continue to fail and fund companies refuse to bail out investors from these so-called “cash equivalents.”
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