Think Your Cash is Safe? Better Check With Your Broker

On Friday afternoon, UBS became the first major investment firm to start "marking down" the value of Auction-Rate Securities held in client accounts (translation: each $1 will now be worth $0.80-$0.95). Why does this matter? Because most people who own Auction-Rate Securities think they own "cash."

Auction-Rate Securities were sold for years as "cash on steroids"--securities that could be sold any time but paid, say, 4.5% interest while chumps who owned money-market accounts were stuck earning 4%. Many people who bought Auction-Rate Securities--and, it turns out, many people who sold them--assumed the extra interest was just a freebie, a riskless bonus discovered by a talented financial advisor. But, of course, it wasn't.

In recent months, the credit crunch has frozen several sectors of the Auction-Rate Securities market, making the securities difficult or impossible to sell. Now, banks like UBS are responding by cutting their value--news that will likely be greeted with shock by many UBS clients, who thought they were holding cash.

There are four key lessons here:

1. There's no free lunch. That "bonus" interest your broker found for you? You're only getting it in exchange for increased risk. On Wall Street, there is NEVER a free lunch, so don't get duped into thinking you've found one.

2. "Cash-like" securities are not the same as "cash." So next time you hear your advisor say "just like cash!", hang up the phone.

3. Your broker/advisor may not know that he or she is selling you something that could lose value. This emerged on Friday, shortly after the Journal story about UBS ran (see Comments). Many brokers who sold Auction-Rate Securities believed that they were safe and are shocked as their clients about what has happened. These brokers are now pointing their fingers at the product people in their firms, who told them ARSs were safe. (This, by the way, is a common misconception about Wall Street: The folks who screw you aren't actually trying to screw you--they're just inadvertently screwing you.)

4. Just because something has never happened before doesn't mean it won't happen soon. The reason your broker and you thought ARSs were a free lunch is that they had seemed to be--for decades. Alas, as the saying goes, past performance does not guarantee future results.

Want your cash to be as safe as it can be? Hold it in FDIC insured savings accounts or money-market funds composed of US Treasury bills. Sure, the interest rates stink. But there's no free lunch.

More on UBS and the coming barrage of ARS lawsuits: UBS Hoses Clients, Cuts Value of Auction-Rate Securities; Lawsuits-a-Comin'

Follow Henry Blodget on Twitter: www.twitter.com/hblodget

Comments

[robinhood1]

I wonder how stable value funds in 401K plans are holding up? Could they be the next domino to fall? My former employer offered this type of fund and it yielded around 4% a few years ago when money market funds were yielding less than 2%. The stable value fund was considered to be the least risky option that we had in our 401K plan.

[TXfemmom]

This was another scam provided by PHIL GRAMM AT UBS.

[robinhood1]

Auction rate securities were around even in the 1990's, although I don't recall any problems with this class of investments. They were never eligible investments for money market funds. However, Orange County, CA's money market securities had to be marked down for a while after the bankruptcy. One fund that I know of took a multi-million dollar hit on these securities, temporarily impacting the yield on the fund. However, I doubt that the average investor in the fund looked closely enough to care.

[bas1311]

Any advice for people who put money in BNBN and AOL when you were touting it, Henry?

[joebhed]

"Because most people who own Auction-Rate Securities think they own "cash."
But, they don't.
How is irt that most "people" do not know what their holdings are?
How is it that even some brokers did not know what their clients are holding?
Following the link to the SAI article shows these brokers claiming they did not know.
We need something akin to a 'Truth-in-Holdings' regulation.
In case nobody else is watching here, this is the way I see it.
The name of the game is - hide the risk from the investor, and leverage that puppy to death.
The so-called IBs who are nothing more than "holding" companies, create an entire free market in "holdings" of technicolor rainbow dimensions, so that nobody knows the real differences between the blues, the grays and the oranges.
"Tell them, it's LIKE money".
At each step in the marketing, the risk gets a little more murky.
Then we get folks who are afraid that there may be Sarbanes-like regulation of these markets in order to protect the consumers of these murky new "money-like" instruments.
Pray tell.

[Halsey]

Henry,

I am a broker..an­d never, ever sold ONE ARS..(auct­ion rate security).­..and no..I don't work for UBS..thank gawd!

but you are correct.I'­ve seen other brokers with LIVID clients..w­ho thought they could get their money out on the next auction...­now they're stuck...bu­t...client­s are also to blame..I lost an account..b­ecause the client said "this "other firm"...ha­d a liquid investment (ARS)..tha­t paid 100 basis points better than our FDIC insured money market... too bad there's no joy in this client's decision to pull his funds from me..and go get locked in... all for the sake of a few hundred bucks a year in interest..­.

This mess will straighten out some day...and we will have a new round of regulation­..and have no one to blame but ourselves (and bill clinton for dismantling glass-steg­all..thank­s Mr. Rubin!)...

My fear is that the feds will go too far (like with Sarbanne Oxley)...i­n regulation­..but...we see what little or no regulation brings us. As long as there are bright, arrogant Wharton MBA's creating snake oil out of mortgages or whatever..­.we are at risk....

[mp905]

Most of the people who put their money in these types of accounts are probably savers, not investors in the traditional sense. They are not looking for high risk/high reward but for security.

My bankers told me that if I did not take some risk that my principal would get smaller over time, chewed up by inflation. Many times, these low risk choices (FDIC money market or bank savings accounts) were only paying 1% or 1.5 % interest.

It is so sad, that so many of us who needed security and liquidity got neither. And mutual funds in the stock market didn't turn out to be a good choice either. My mattress looks better every day; no fees, no worries:)

[racom]

Henry, good comment. I, as most, do not work in the financials or securities markets and find it utterly confusing. I am fortunate in that my retirement money comes mostly from the old, union fought for, pension funds. I do find it ironic that two of the financial gurus mentioned by Hillary to fix todays problems were Greenspan and Rubin. Why not two used car salesmen? It is not about experience or capabilities, it's about trust.

[ProudNeoCon]

Just to be clear - most of the Money Market acounts are not FDIC insured either. Only Money Market Deposit Accounts are. However most ofthe people have Money Market Mutual Funds and those are trated as a regulat Mutual Funds and are not insured.

I work in Financial industry for long time. In my personal life I was pitched ARS very aggresively by my bank about 4 years ago. I bought it for 1 month, but after reading the actual documents, I got out. I have found that the broker selling the product did not know the product well enought to understand what additional risk is being taken for extra yield.

In short ARS are good and proper instruments. BUT they are not same for cash and should have never been marketed as such. Moreover they are not for "pop and mom". This product is designed for investor who actually read prospectuses and do not rely on broker to tell them what to do.

All investors have to remember - there is no free lunch. Before trading or inveting they need to ask themselves if they understand the product and if they can explain it to their 10 year old kid. If they can not - it is too complex for 80% of the people and they should not touch it...

[joebhed]

Actually, if you don't mind - it is not the ten-year-old who needs the understanding.
It is each and every market player whose hands touch the new fandangle.
Why was it not incumbent - from a legal perspective - for your bank to fairly and reasonably inform you of the risk of investing in the ARS holding some four years ago?
You know, like "truth-in-lending"?
It took a financial guy/gal a month to figure it out.
Why don't they go to jail for not telling people the truth about the guarantees and warantees on the product they market?
Why doesn't every one of those "e-trade" advertisements start out with a government disclaimer - "Let The Buyer Beware" what comes next.?
For the most part, small investors are not looking for a free lunch.
But they do want to know if what they are buying can kill them or not.
Quite frankly, if we ever sort out the "financial services industry" in this country so that investment banks are only capable of playing with their own money, I have no problem with them playing by their own rules.
But the IBs are well over a hundred LARGE and counting on the public teat here, and it's starting to look like real money.
I say abolish the private banking system and put the government in charge.
As in the Chicago Plan of the '30s.
Protect the public and let the rich kids steal each other blind.