Auction-rate bonds leave many investors hanging

Matt Krantz - USA Today

Q. My broker told me it was safe to put almost my entire life savings into bonds sold by the Missouri Higher Education Loan Authority. But the interest rate has fallen from nearly 6% to about 2% and I'm told I can't sell. What should I do?

A: Sounds like you've been sucked into the credit-crunch vortex.
What you, and many other investors are stuck with, are what's called auction-rate securities.
Auction-rate securities are bonds sold by municipalities and mutual funds that, on paper, were ingenious. These were long-term bonds that gave these borrowers access to money for 20 or more years. Buyers also got higher yields than they'd get on money market investments.

But, what's different, is that auction rate securities don't have a stated interest rate. Instead, the bonds are supposed to be offered in a periodic auction, ususally every 7, 28, 35 or 49 days, and investors would bid on them. The interest rate would be reset depending on the auction results. The more bidders, the lower the interest rate.

In theory, it's a good idea. Borrowers can access money for long periods at what are basically short-term interest rates. And investors who need their money back after a short term, in theory, can sell their securities to other investors. The theory, unfortunately, blinded many brokers who suggested these investments to clients and said they were as good as money in the bank.

In February, investors got a rude awakening. It turns out many of these auction-rate securities only had high credit ratings because they were guaranteed by large bond insurance companies. When the insurance companies ran into trouble, due to their exposure to sub-prime loans, investors realized the safety net for many auction-rate securities was gone. Suddenly, new investors weren't willing to bid in the auctions — leaving existing investors like you holding the bag. If there are no buyers for the bonds bidding in the auctions, you can't sell yours.

So the question is: What should you do now?

Step 1: Don't panic. You're not alone. Regulators are aware of the problem and are looking into it. State regulators from Florida, Georgia, Illinois, Massachusetts, Missouri, New Hampshire, New Jersey, Texas and Washington are all investigating this matter as part of a initiative from the North American Securities Administrators Association. You can read more about the investigation by clicking on the link below.

FROM OUR ARCHIVE: Read about the auction rate investigation.

The Securities and Exchange Commission is also aware of the problem. ""While we cannot disclose specific matters, as a general matter, we are looking at representations made to investors when they purchased auction rate securities, in coordination with FINRA," John Heine, spokesman for the SEC, said in an e-mailed response.

The SEC has, as long as two years ago, slapped brokerages on the wrist over the way the auctions were conducted. This action shows that the SEC is aware of this market and the abuses in the past.

PREVIOUS SEC ACTION: From 2006.

Step 2: Run up the chain of command at the brokerage. If you don't get any help from your broker, call your broker's boss and if necessary, keep working up the chain, says Sally Hurme, an attorney for the AARP. The question at hand is whether your broker sold you an investment that was "unsuitable," which is a word you should use because it will get attention at the brokerage. That is, did he or she know you needed a stream of income and he told you this was a risk-free investment that would provide it. Regulators have been paying keen attention to suitability of broker recommendations, Hurme says.

Gather as much information as you can about your investment. Ask the brokerage firm what it will do for you. Also, ask for any documents about the security you bought. Ask for the prospectus on the security. That will contain details about the bond that you own.
Also, on your brokerage statement, you should see the CUSIP number for the bond you bought.

The CUSIP number is like a ticker symbol, or identifier of the bond. Run that CUSIP number through Finra.org, which is one of the leading regulators of the securities industry. Here's how:
1. Go to finra.org/marketdata
2. Enter your bond's CUSIP number on the "Search" box in the upper right-hand corner of the page. Change the pull-down box to bond and click the Go button. The CUSIP on the bond you're asking about is 606072HM1. Click on the name of the bond. Here's where you can look up some details on the bond.

Regarding your specific bond, using the FINRA site and a Bloomberg terminal, I can tell you that the bond appears to come up for auction once a month. The next auction is scheduled for May 1. Tell your broker to try to sell your bonds. Who knows, you might get lucky.

Step 3: If you can't sell your bond and the broker gives you no satisfaction, contact the regulators. You'll want to canvass all the regulators and let them know you're one of the victims, Hurme says. That includes FINRA, which oversees the brokers.

COMPLAINT CENTER: For the Financial Industry Regulatory Authority.

Next, make your situation known to all the states involved. That includes the state you live in, the state the broker is located in and the state the bond issuer is in. A great place to do this is with the NASAA, at www.nasaa.org.

Click on the "Contact your regulator" link on the left-hand side of the page. Click on each state that's affected, and you will get contact information. When you call or contact the state regulators, make sure you have the bond CUSIP number and information about your broker.

Finally, let the SEC know. There is a section to file complaints here.

Step 4: Weigh your options. You essentially have four immediate options as you wait to see what the regulators do: Hold on to your security, try to sell it, borrow or sell other asset to help you through.

Each course has its own risks. Holding on, in some cases, might work. There are some auction rate securities that failed in February that are now functioning. The auction rate bonds sold by the Metropolitan Museum of Art, New York, for instance, failed, but are trading again.
You may not be as lucky. The type of loan you own, student loans, is one of the worst performing areas of auction-rate securities. Investors are fearful of credit risk and are unwilling to bid so far. Plus, it looks as if when an auction in your bond fails, the rate goes lower, not higher. That means there's not exactly going to be a line forming of people willing to bid for the auction at the low rates.

It's possible the issuer of the bond will try to restructure its auction rate bonds by selling new bonds to replace yours. But that's unclear in the tight credit market. Again, student loans continue to be one of the worst spots in the auction rate market. The student loan organizations don't have many options available to them.

Will Shaffner, spokesman at the Missouri Higher Education Loan Authority, told me April 25 the student loan market remains difficult. "The auction rate note market to students loans is still not functioning," he says. MOHELA is working to find a solution, since the problem is costing them, too, with high interest rates on some other bonds that have failed, he says, and causing difficultly in raising more money. MOHELA is seeking Congress' help in finding a solution to get the market for student loans functioning again, he says. Here's the latest information about the bonds available on the website (pdf).

That leaves the option of selling the bond. But again, this isn't going to help you since your bond is student loan backed. Your brokerage may allow you to borrow money, but you'll likely pay interest on that or, they will want you to sign a document saying you won't sue them in the future. You may be able to sell other assets and wait this out, but then, you're eating into your nest egg further and may have capital gains that create a taxable event for you.

Get more details on these options here.

Step 5: Consider legal representation. Even if the regulators do tackle these cases and win, it could take years before you see a penny. If you've pursued all the steps above and don't get anywhere, you may consider a lawyer, Hurme says. The lawyer may be better able to use language with the broker to get more satisfactory results. There's also a chance you can take the brokerage to arbitration and try to get a settlement that way.

There are also attorneys who are pursuing the possibility of pooling many investors who bought these investments into a super suit. Girard Gibbs is one of the law firms that has filed a complaint against leading investment banks and brokerages including Citigroup, UBS, Wachovia, Merrill Lynch, Wells Fargo, Morgan Stanley, J.P. Morgan Chase and TD Ameritrade over this issue.

Daniel Girard, partner at Girard Gibbs, says investors will not be precluded from pursuing claims in arbitration against brokers even if they join the preliminary formation of the class action. "People don't need to make a choice now," he says. You can get more information about the action here.

As you can see, there aren't many great options at this point. Your best hope is that somehow the credit crunch eases and either the auction-rate security starts trading again or the issuer may refinance the debt.