Wake up Wall Street. Joe Investor is hurting too
Big brokerage firms aren't the only ones socked by the freeze in an arcane investment known as auction-rate securities. Everyday investors are wheezing too.
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NEW YORK (Fortune) -- UBS brokerage customers who own supposedly liquid investments known as auction-rate securities have had the value of their investments marked down by the Swiss bank, increasing fears that people with money frozen in this market will not get their principal back.
Auction-rate securities are long-term bonds that hospitals, cities and corporations sell at weekly or monthly auctions, which is the reason that many investors, until now, have treated them like cash investments. But those auctions began to fail in February as the credit crisis deepened and big buyers of auction-rate securities, among them Goldman Sachs (GS, Fortune 500), UBS and Merrill (MER, Fortune 500), found themselves too cash-strapped to step in and buy unsold bonds. Without any buyers, the auction-rate securities market came to a standstill.
As a result, more than $300 billion is now frozen in auction-rate securities products, with no way of knowing if or when the majority of auctions will resume. Anywhere from $30 billion to $60 billion could be money from individual investors, according to several fund managers.
Throughout the debacle, brokers and asset managers who sold auction-rate securities have claimed that this is merely a liquidity problem. They have reassured investors that the securities will keep their full value and simply pay higher interest rates while the assets are frozen.
But the Wall Street Journal reported on Friday that the UBS markdowns will range from a few percentage points to more than 20%, and that they reflect the estimated drop in value of the bonds now that there are no buyers. The bonds will be marked back to face value if the auction-rate securities market rebounds, but the move by UBS (UBS) has increased worries that these securities may be worthless.
"We are working with clients, on a case-by-case basis, to address their immediate liquidity needs, offering such solutions as margin loans and lines of credit at preferred lending rates," says Karina Byrne, a UBS spokeswoman.
Even before UBS marked down portfolios last Friday, there were rumblings that the auction rate market had been fundamentally changed by the liquidity crisis.
"It is difficult to conceive of a scenario where the auction rate market returns to its historical behavioral patterns. The auction market must now be redefined, both in terms of relative pricing (we'll venture that yields would be higher than in the past) and the investment objectives of its holders," says a report issued in early March by Samson Capital Advisors.
Yields would rise to pay investors for the fact that auction-rate securities will never again be considered as liquid or as safe as cash. The introduction of risk and higher yields would also mean that prices for these bonds would drop.
In a positive sign for investors, the market for auction-rate municipal bonds has revived in recent weeks. The attractive yields these muni bonds are paying, some as high as 15%, have attracted buyers like hedge funds. These bonds make up about half of the auction-rate market.
Some auction-rate bonds with a maturity date also have a chance of holding their original value. Investor money may be tied up for the life of a bond, in many cases 30 years, but that bond will eventually be paid in full.
Unfortunately, many retail investors hold auction-rate preferred shares in closed-end funds that don't have a maturity date so there is no exit. These funds account for about $65 billion of the auction-rate market and the money in these products is tied up until the fund itself is liquidated or the auctions start running.
Barry Silbert, chief executive of a company that has created a secondary market for the bonds, agrees that a lot of the non-muni market will lose value.
"Of the $300 billion-plus market, between 10% and 30% of it will never trade at par again and I'm leaning more toward 30%," says Silbert, who runs the Restricted Securities Trading Network.
Selling at a loss on the secondary market is not good for investors; but those who need cash immediately will have to sell at a loss in order to get at their funds. Some desperate investors who need money to pay bills and taxes have filed class-action lawsuits against the brokers who sold them these securities.
Asset managers are scrambling to repair the damage that auction-rate problems have done to their reputations. Three funds run by Eaton Vance have already liquidated some auction rate securities and returned money in full to investors. (See correction at end of story) Big names like Nuveen, which has about 30% of the auction-rate market for preferred closed-end funds, and Legg Mason are also working hard to calm investors, though they are reluctant to liquidate funds.
Legg Mason said Friday that it was trying to restore liquidity to shareholders of auction-rate preferred securities issued by its seven LMP and Western Asset branded closed-end funds. Collectively, these funds have issued about $672 million in auction-rate preferred securities.
As for investors who say that managers guaranteed a cash-like investment and are obligated to give them their money back, John Calamos, co-chief investment officer at Calamos Investments, has little sympathy. He says investors should have read the prospectus and known the risks.
However, Calamos admits that even he was blindsided when banks let the auctions fail.
"They dropped a bomb on us by letting the auctions fail. It is unprecedented," says Calamos. Much like the investors, he believed the auction-rate market would function smoothly, despite the fact that the big banks were not legally obligated to keep the auctions running smoothly.
"Making markets is what these banks do. Why do these institutions exist if they're not there to serve their clients?" asks Calamos.
For now, asset managers are the ones dealing with angry investors. "While I blame my broker, I realize that the answer at this point lies with the fund companies," says Joseph Lanzisera, who has money frozen in several closed-end funds. "They have my money and the ability to refinance or liquidate fund assets to help me."
Correction: An earlier version of this story incorrectly said that Eaton Vance had lost money when it liquidated auction rate securities from its funds. 
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