The auction-rate securities market collapse in February left investors with questions of what to do with their now-illiquid auction-rate investments. So far, no one has come up with a permanent solution, and experts predict that the broken market can never fully return to its former status. In fact, Citigroup, the leading underwriter of auction-rate notes since 2000, proclaimed the future for auction-rate securities to be all but dead.
Auction-rate securities were created more than two decades ago as a way for local and state municipalities, hospitals, student loan companies and others to borrow money for the long term at short-term interest rates and resell the debt at auctions held every seven, 14, 28 or 35 days. Everything ran smoothly - for a while. Problems first started last year, in the heat of the credit crunch, and investors began fleeing the auction market. With no bidders, the investment banks, which previously prevented auctions from failing, started pulling back on their promise to buy the auction securities.
This caused an unprecedented number of auctions to fail, leaving individual investors with long-term securities they could not sell.
Itâ€™s not just the wealthy who find themselves out luck from the auction-rate securities fiasco. Small business owners, retirees, families saving for a new home or their childrenâ€™s college education are in the same predicament. And, in most of the cases, the blame rests firmly with Wall Street for hiding known risks about the auction securities from investors.
Finger pointing aside, investors now want to know their escape options. The short answer: It depends on the type of auction bond investors hold.
Some auction-rate securities that failed six months ago are now trading again. In some cases, issuers such as certain closed-end funds have started to redeem shares, sometimes at par value. Other issuers of auction securities are offering to redeem only some of the outstanding shares, meaning not every share that investors hold will be redeemed.
Many investors, however, are in a far worse situation. Student loan-backed debt continues to be the poorest-performing segment of the auction market - about 99 percent of the public auctions for auction-rate securities sold by student-loan agencies and closed-end funds continue to fail, as do nearly 50 percent of municipal auctions.
For investors who need immediate access to cash, the options unfortunately are few and far between. They can elect to sell their holdings on the secondary market - albeit for a significant discount.
In some cases, investors have been allowed to â€œborrowâ€ loans from their broker to cover cash-flow needs, using the frozen securities as collateral. Keep in mind, however, electing this option means you will interest and, in some cases, be required to sign a release form stating you do not plan to take any future legal action against the brokerage.
In addition, borrowing against a tax-exempt security could cause investors to lose the ability to deduct interest or a portion of the interest on the margin loan from their income taxes.
Securities regulators are aware of the problems facing investors from the collapse of the auction-rate market, and are looking into the issue. State regulators in 10 states, as well as the Securities and Exchange Commission (SEC) have launched investigations into investorsâ€™ claims that Wall Street investment banks failed to disclose the liquidity risks of the instruments to them.
The Financial Industry Regulatory Authority (FINRA), the self-regulatory watchdog of securities dealers in the United States, has created a special section on auction-rate securities and what steps investors can take on its Web site. Visit http://www.finra.org/ for more information.
Meanwhile, one additional option is gaining favor with investors who find themselves caught up in the failed auction rate securities ordeal: legal representation. The growing number of class-action lawsuits filed against brokerages that sold auction-rate securities as cash equivalents has evolved into nothing short of a phenomenon. Across the country, brokers at nearly every major Wall Street firm face legal action for their mishandling of auction-rate securities, and faith in the broker-model becomes just a memory of the past.
Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.