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Collapse Of Auction-Rate Securities Reminds Buyers To Stay Cautious

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By JOHN F. WASIK

Bloomberg News

Published: September 3, 2008

Some investments need a plain-language warning sticker that you find on a stepladder or a crib.

Caution was lacking for auction-rate securities, complex vehicles that were sold by brokers to institutions and individuals. They were bonds or preferred stocks that had interest rates periodically reset through auctions, which failed after the subprime-market meltdown.

Why did individual investors get the idea that these securities were liquid cash equivalents like money-market funds?

The disclosure from brokers wasn't adequate. People such as Julian Dibbell, a writer from Chicago, bought them on the premise that you could get your money out at any time.

The $330 billion auction market for these securities collapsed late last year, and investors couldn't cash out.

The $200,000 that Dibbell invested through Chase Investment Services Corp., a unit of JPMorgan Chase & Co., was frozen, and his statement at one point indicated the value of the securities, tied to student loans, was "zero."

Dibbell had purchased the securities with the proceeds from the sale of his late mother's home in California. He was hoping to buy a house.

Although interim loans from Chase and a recent settlement - one among several between regulators and brokers - allowed him to close on his house, he was dangerously near to cashing out a retirement account. That withdrawal would have triggered $10,000 in taxes and penalties.

'Happy Ending'

"Chase has settled with the New York State Attorney General's Office and will be buying my troubled shares back at par value," Dibbell said. "I'm taking this for a happy ending so far."

When he was sold the securities, Dibbell said, "there was no discussion of risk."

What went wrong, and how did these troubled investments end up in the hands of individuals? Which regulator neglected to check that folks like Dibbell were fully informed of the risks of these securities? Clearly there wasn't enough disclosure since retail investors bought about $165 billion of these vehicles.

"Based on the hundreds of complaints received, investors were not informed of the liquidity risks and received little disclosure," said Karen Tyler, president of the North American Securities Administrators Association, a state regulators group. "They were marketed as a safe, money-market cash equivalent."

Now regulators, led by de facto federal securities cops, New York Attorney General Andrew Cuomo and state agencies, are inspecting about 40 brokerage firms to see whether they gave ample warning to their clients on auction-rate risks.

So far, state and federal regulators have reached settlements with eight major banks and broker-dealers to buy back more than $35 billion of the securities from investors.

The firms have been fined more than $522 million, paling in comparison with the $5 billion in penalties for the mutual-fund late-trading scandal in 2003.

Small investors seemed to be the last to find out about auction-rate pitfalls even though it was known that there were significant conflicts with these securities five years ago.

The Securities and Exchange Commission cited problems in this market going back to 2003. After a probe, the agency fined 15 firms more than $13 million combined in May 2006 and issued cease-and-desist orders, citing "violative practices."

"Since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks," the SEC stated.

"Auction-rate securities have been a cesspool for a long time," said Andrew Stoltmann, a Chicago-based securities lawyer. "In the last seven years, they've spread to moms and pops in $25,000 increments."

Once again, the combination of a weak industry self-regulatory system, diffuse territories and the SEC's slow action led to individual investors being misled.

What To Do If You've Been Burned

Have you been burned by a broker in an auction-rate security? You have a few options.

•File an arbitration claim. Under the terms of the settlement, the companies involved have agreed to an elective process where the firms "will not contest liability for its misrepresentations or omissions concerning ARS," according to the SEC and state regulators.

•Litigation. More than 200 class-action suits have been filed. They take years to litigate, are costly, and you may end up with a paltry settlement.

•You could also badger your congressional representatives to create a tough, independent regulator that represents individual investors and mandates plain-language disclosure.

Would better disclosure make a difference? Aware that current investor communication isn't working, the SEC discovered that more than two-thirds of the mutual-fund holders who were surveyed "rarely or never" read prospectuses.

The SEC has commissioned an internal study known as the "21st Century Disclosure" initiative that is intended to be a "blueprint for future Commission action to improve the usefulness and timeliness of disclosure."

It's unlikely that federal regulation will change much in the near future to help individual investors.

In the meantime, keep in mind that your broker is often poorly policed when it comes to selling certain investments - and may not tell you the whole truth on the risks involved.

John F. Wasik is a Bloomberg News columnist.

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