(USA) New Trouble in Auction-Rate Securities

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Market Place

New Trouble in Auction-Rate Securities

February 15, 2008

SOME well-heeled investors got a big jolt from Goldman Sachs this week: Goldman, the most celebrated bank on Wall Street, refused to let them withdraw money from investments that they had considered as safe as cash.

The investments at issue are so-called auction-rate securities, instruments at the center of the latest squeeze in the credit markets.

Goldman, Lehman Brothers, Merrill Lynch and other banks have been telling investors the market for these securities is frozen — and so is their cash.

The banks typically pitch these securities to corporations and wealthy individuals as safe alternatives to cash, investors said. The bonds are, in fact, long-term securities. But the banks hold weekly or monthly auctions to set the interest rates and give holders the option of selling the securities.

Only this week almost 1,000 of these auctions failed. The banks also refused to support the auctions, leaving many investors wondering when they will get their money back.

“Investors have lost confidence in the liquidity of these instruments,” said G. David MacEwen, the chief investment officer for fixed income at American Century Investments, a mutual fund company. “These types of instruments depend on new investors showing up to own the securities.”

The $330 billion auction-rate market is dominated by municipalities and other tax-exempt institutions like the Port Authority of New York and New Jersey, which had issued some auction securities and had its interest rate soar to 20 percent on Wednesday. Closed-end mutual funds, student loan companies and corporations also issue such securities.

A failed auction does not mean the securities go into default, because the issuer continues to pay interest at the higher rate, or “fail rate.”

The market, however, has a troubled history. In 2006, the Securities and Exchange Commission reached a $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market.

The S.E.C. investigation centered on how bidding was conducted for these securities. Critics complain that investment banks have the upper hand in bidding because they can bid after seeing what other investors have bid.

Brokerage firms are not legally obligated to make a market in auction securities, or give clients a price even if there is not one in the market. But clients who are unable to sell are likely to argue that they were wrongly put into long-term securities when their intention was to buy shorter-term debt.

“If these were pitched as cash equivalents, if that is what the broker said they were, the banks may be held responsible for losses and clients’ inability to get their money out,” said Jacob H. Zamansky, a securities lawyer who represents individual investors.

Goldman Sachs and Merrill Lynch declined to comment.

The situation is an awkward one for investment banks and brokers that have had to tell clients that their cash is frozen until at least the next auction — if not longer. One affluent New Jersey family has sued Lehman Brothers for the declining value of its cash in auction-rate securities. Lehman has said it acted properly.

Money managers, chief executives and individual investors have been swept up by the latest turmoil in the credit markets. One wealthy investor said Goldman Sachs had sold him auction-rate securities and had described the instruments as equivalent to cash.

“It’s a moral outrage,” said this investor, who asked not to be named because he still has to deal with the bank. “Their pitch was, keep your cash with us, we get a higher rate.”

This year, Bristol-Myers Squibb, the drug maker, took a $275 million write-off on money it had invested in auction-rate securities that it was unable to sell because of failed auctions.

Analysts say the biggest investors in auction-rate securities are individuals and corporations because money market funds cannot own the bonds. Many bond fund managers also shy away from the securities because of the uncertainty.

But the failed auctions do have one upside: the securities are resetting to rates that are far higher than those on other types of bonds.

Mr. MacEwen of American Century said his firm was considering buying auction-rate bonds for the first time because the rates have been reset to an attractive level.

“A lot of the municipalities or the closed-end funds that underlie this are high quality,” Mr. MacEwen said. “Whether its 20 percent or 5 percent, that looks like a good purchase if you are willing to forgo the liquidity.”

Not all auction-rate securities with failed auctions are resetting to very high rates. The penalty rates are governed by the terms of the bond, and in some cases they are tied to short-term interest rates like the London interbank offered rate, which has been falling for much of the year as the Federal Reserve has cut its benchmark interest rate.

Andrew Ross Sorkin contributed reporting