The Auction Rate Bonds Mess: To the Depths of Depravity and Beyond!
Remember the analyst fraud scandal? Major brokerage firms agreed to a $1.4 billion fine to settle charges that their research misled retail investors. At the time, the finest PR firms and lobbyists in the world assured investors that Wall Street had "cleaned up its act". We heard a lot about a "Chinese wall" that was supposed to protect analysts from being pressured to enhance the ratings of institutional clients.
Trusting investors bought the pitch and returned to the warm embrace of this disgraced industry in droves.
Fast forward five years.
UBS, Merrill Lynch and Citigroup have announced settlements with regulatory agencies that will require them to purchase $40 billion of auction rate bonds held by their retail clients and to pay substantial penalties. Other firms are under investigation and are likely to agree to similar settlements.
In the analyst fraud cases, the firms never agreed to make restitution to their clients. They got off cheap, secure in the knowledge that the FINRA mandatory arbitration system would protect them from any meaningful awards. Their trust in this flawed system proved to be right on the money.
What's different now?
The evidence of total depravity and greed by the securities industry in misleading investors about the relative safety of these bonds is so overwhelming and disturbing that the industry hopes to quickly sweep this issue under the rug. Clearly, if investors understood how they are used as cannon fodder to generate profits, their confidence would be completely undermined.
The Elliott Ness of securities regulators is William Francis Galvin, the Secretary of the Commonwealth of Massachusetts. Galvin has been a leader in aggressively going after Wall Street firms that plunder the savings of investors using deceptive and unfair tactics. He has had no shortage of ammunition.
On July 31, 2008, Galvin's Office brought an Administrative Complaint against Merrill Lynch. It set forth the details of Merrill Lynch's sordid conduct in connection with auction rate securities. The e-mails detailed in this complaint provide insight into the motivations of your "trusted financial professionals."
One analyst had the temerity to question the liquidity of these bonds. After a flurry of internal e-mails, he was asked to change his opinion and endorse these securities "as a buying opportunity for investors..."
When another analyst was answering questions about auction rate securities in a conference call with retail brokers, his boss e-mailed a message ordering him to be "shut down" because he was not being positive enough.
When the market showed clear signs of failing, Merrill Lynch was undeterred. In one particularly sickening e-mail, a Merrill Lynch executive brushed off the signs of market distress by cryptically noting "Gotta Move these microwave ovens!!"
On February 12, 2008, Merrill Lynch stopped supporting its auction bonds and many of the auctions failed as a result. Yet, only 5 days earlier, the retail brokers were told that "Merrill Lynch certainly by all indications, is committed to this product."
The Administrative Complaint alleged that "[W]itness testimony before the Division confirms that Merrill Lynch's decision to stop broadly supporting its auction program was made without any consideration or analysis of its effect on retail or other customers holding these securities."
Do you really have to wonder why retail investors were tossed under the bus?
Could it be.....fees?
The Complaint alleged that "Merrill Lynch reaped a total of approximately $90 million dollars in total profits" from its auction rate program in 2006 and 2007 and that it "...had a significant interest in keeping its issuer clients happy in hopes of securing future business with those clients."
Sound familiar? Just like the analyst scandal, the interests of the average Joe were sacrificed to keep those big fees rolling in.
There is a fine line that separates the admirable quality of forgiveness from the sad one of being a sucker. When you consider doing business with these firms, you need to decide which side of that line you are on.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.
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A major defect of the US economy is that so many people are reaping huge rewards for moving money from one pocket to another.
They create no value - yet they get rich.
A major overhaul of the financial regulatory system is sorely needed.
"Money for Nothing" , they love the song it discribes their work and thier values.
Unfortunately thats what our money will be worth if Mc Cain is elected.
A bunch of lying thieves runs our money system.
So, what's new, Dan?
And, what are we going to do about it?
"There are no greater human and civil rights violations than the withholding of economic and financial livelihoods of peoples.
There is no greater "terrorism" than financial manipulation of the peoples’ livelihoods for political and financial gain.
The educators, the ministers, the rabbis, the political leaders, and the peoples’ elected representatives, including in the United States, emerge as the unwitting "terrorists"—who in silence, some perhaps for financial and political gain, condone Capitalism’s (Bankerism’s) recondite harvesting of the fruits of the productive society’s labors."
Peter Cook, Monetary Science Publishing, in "Reserves, Deposits and Central Banks".
The financial terrorists are among.
"HOW DOES IT FEEEEEL...
I'm reminded of what Michael Mukasey said about the Justice Department, "Not everything that's against the law is criminal." Regarding Wall Street, not everything that's criminal is against the law.
Add the number of corporations and companies sued in class action lawsuits almost every week and you have a totally unregulated free market system out there waiting for the unsophisticated public to come in to get ripped off. These are indeed signs that we have passed our prime.
That's VERY kind of you.
my sincere appreciation to dan solin and charlesmac for their informative responses to my inquiry and again to dan for the post, in the first place. the books you have recommended are next on my list.
Most retail investors are no match for "full service" stock brokerage firms, financial planners or insurance salesmen selling variable annuities. If you don't know enough about investing to use a discount broker or no load mutual funds, keep your money in an FDIC insured bank account. There is so much investing information available at little or no cost on the Internet, at the public library or even at your local book store, where I quickly read through Dan Solin's book on 401K investing in an afternoon, for free. If you depend on a salesman for investment advice, you have no one to blame but yourself. Let the buyer beware.
THERE'S NOTHING CRYPTIC ABOUT THE NOTE ABOUT MICROWAVE OVENS. I WANT MY MTV "MONEY FOR NOTHING AND CHICKS FOR FREE"
SEE MARK KNOFPLER, A CONTEMPORARY OF THE GENIUSES RUNNING WALL STREET TODAY.
The Authorities still refuse to deal with the underlying problem in all these scandals.
There is currently not much of a downside risk for the officers at the very top of the brokerage firms and banks for allowing their subordinates to play fast and loose with the truth when constructing and selling these exotic instruments.
They get the upside benefits by way of increased salaries & bonuses, and whilst the sun still shines are often lauded by the analysts and press for their brilliance. But when it all implodes they merely get the brokerage firm or bank that they run to pay any fines. Personally at worst they may lose their jobs (albeit with a massive payoff), but then often seem to fairly quickly bounce back into another highly paid position.
Until they are forced to stand trial in a court of law for their actions, they and their successors are likely to allow the same criminal behaviour to continue. I realise they will raise the old argument that they didn't know what their subordinates were doing, but it's about time a jury consign that defense to the trash can.
Staggeringly you then often have the same analysts and press who cheered on the way up, applauding the paying of a fine to settle the cases, because as they see it, a distraction for the business going forward is removed, seemingly not realising that it is likely to condemn the industry to a repeat performance a few years later.
Downside Risk. Nice term. That is the economic name for ‘Paying the piper’.
Not much Downside Risk? You mean like stealing a billion and then getting fined 200 million. No jail time, no real punishment of any type.
That will teach them not do it again!
Perhaps it is time that we start burning Ferrari’s and 60 ft yachts in effigy.
Where are the client's yachts? Oh, they don't have any?
HuffPost's Pick
Oh, these are not going to fit under any rug. As small retail clients' "good as cash" instrument turned into an illiquid "bond without end"... treasurers of corporations had to march up to the CEO's office and start off by saying "You know those $ XXX million "Cash and Equivalents" on our balance sheet?.... Well, they ain't anymore."
The timing of these Auction Rate Securities is sublime.
Right when companies need sturdy cash on their books, they get clipped. When ARSs fail at auction, depending on the original issuer, the interest accrual rate can jump substantially. Companies like American Eagle Outfitters and Bed, Bath and Beyond have had to shuffle off $100s of millions of cash to Long Term Investments.
I don't know the answer to the question, but how long before these dead ducks assets have to be marked-to-market, when there is no primary market?
And asset managers, like Legg Mason, have them in their tradebooks. LM has them in, the worst of all places for something illiquid, the money market. It is costing them $100 million a quarter to make good for the ARSs and other SIVs.
All of this is going to make shareholders, the opposite of happy.
So far, 99% of companies have sat on these blisters, and acted like they aren't a problem.
But as time passes, the blisters are going to break.
There are $380 billion of them.
They don't make carpets that big.
Is CharlesMac one of Phil Gramm's whiners?
a few months ago, my guy at morgan stanley offered me the opportunity to invest in something called a 'MARS' account. one of the key selling points to me was that it was liquid. i could convert to cash within a day if i wanted.
at some point many weeks later, i got a call from him informing me that i wouldn't be able to convert them as quickly as originally promised - that it might take two or three weeks or so. since i did not foresee any need for cash in my immediate future, i was fine with that and told him so.
i have since sold those holdings.
but last week, when this ARS / a.g. cuomo thing erupted publicly, i sensed a similarity and emailed my guy to inquire just how similar ARSs were to MARSs. here is the salient portion of his reply:
"The big issues relate to ARS - Auction Rate Securities. We had MARS, Municipal Auction Rate Securities. And although they are in the same realm, the problems were not nearly as exacerbated and seem to have abated. While there was some illiquidity for several weeks, investors were paid large rates of tax free interest in the meantime. The ARS, are still locked up in many cases and do not have the higher penalty rates. It's a much different mess, and I had no dealings in those securities
now i'm wondering if i've been deceived? anybody knowledgeable care to comment?
The foundation of all returns is risk. If you are told that something is as good as cash, then logically it should have the same return as "risk-free" securities (FDIC insured CDs, treasury bills, notes and bonds).
With ARS and MARS, investors were told they could get a better return with no additional risk. This would be the proverbial free lunch. It simply was not true, as many investors have now found out.
The liquidity of MARS has definitely been affected by the ARS crisis. Investors in MARS face continued market uncertainty. I don't buy your broker's efforts to distinguish between the two. If he told you that MARS were essentially as liquid as cash, he was wrong and he should accept responsibility.
part 1
A Municipal Auction Rate Security IS an Auction Rate Security. The guy is parsing names. They go to exactly the same dutch auctions, which don't exist anymore. He is distinguishing it by its original issuer. Municipalities and State Tuition Assistance Agencies are two primary issuers of the ARS "bonds".
Bonds are what they are, except they have long, long maturity terms to them. 30 years is common and there are ones with 50 year maturity dates.
It was how they were used which screwed everybody. And it was the Big Investment Houses that enabled it. They ran the auctions. They also would pick up some portions of the ARS for sale, if there weren't enough buyers that day. They greased the process and picked up fees and charges for running the auction. The beginning of the end was when they Houses started squatting on their capital. They would run an auction and there wouldn't be quite enough buyers for the full amount of the ARS, but the House wouldn't step in and pick up the open piece. So the the auction "failed" because the ARS wasn't sold in its entirety. Then came the point where nobody wanted anything to do with debt backed securities at all.
part 2
These "bonds" were used by companies to park their cash for brief periods of time. They could have the cash back in as little as 7 days at auction. They were passed on and on. From one company to another, and another, and another. The term and risk were immaterial while the auctions ran. Until the music stopped. Then their cash became an usellable long,long term bond and risk IS a concern.
Your broker's letter is fraudulent. Probably not intentionally, because even the guys at the front desk didn't know how they worked.
Simply ask him, how many of the municipal ARSs have sold at par value in the last 3 months. The correct answer is zero.
In an honest system , this would all be preventable.
Accounting-wise, which is from where we interpret financial condition, the only question is whether these fit the definition of 'Cash or Cash-equivalents".
ARS's were created as financial instruments, to play within one of the fields under the bailiwick of the Securities and Exchange Commission.
As they were being created, that is from a notion to a substance, all that was required was a clear opinion or a regulatory order from the accountants at the SEC that these types of securities DID or DID NOT correctly fall under the accounting classification of "Cash and Cash Equivalents".
If they DID, then there was nothing wrong with traders claiming that they were the same as cash.
If they DID NOT, then the traders all had to know they were lying when they made any such claim.
Go DIRECTLY to jail. Do not pass GO. No "Get-out-o
Merrill Lynch handled our 401k. They kept us in oil and oil machinery like refineries and drilling machines. It didn't do well at the time, because it was during the bubble on technology. When the bubble started busting, they sold our oil and machinery shares all at once, not even trying to get a good price, then put us in tech as it was starting down. They cost us a lot of money. I will never forgive them. We knew nothing about funds and we did like they said on all the finance shows, we bought a growth fund.
This is a sad, but all too common, story. Investors need to educate themselves and not rely on the "financial pornography" that dominates the media circus. An easy way to begin would be to read John Bogle's excellent (and easy to read) book, The Little Book of Common Sense Investing and my books, The Smartest Investment Book You'll Ever Read and The Smartest 401(k) Book You'll Ever Read.
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