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'