What Is an Auction-Rate Security?
Auction-rate securities are long-term bonds with floating interest rates that are reset at regular auctions, typically every week or every month.
According to Morningstar, the size of the auction-rate market is around $200 billion and the securities may be issued by municipalities or through closed-end mutual funds. Their floating interest rates provide short-term characteristics that were attractive to some investors.
What would you do if, suddenly, you couldn't cash in certain investments? That's the problem now confronting some investors who thought they had put their money in super-safe securities.
As a result of the credit problems on Wall Street, many people who bought auction-rate securities are finding they can't get their money back when they want to.
Auction-rate securities are long-term bonds with floating interest rates that are reset at regular auctions, typically every week or every month. According to Morningstar, the size of the auction-rate market is around $200 billion and the securities may be issued by municipalities or through closed-end mutual funds.
But some regulators said they were sold as highly liquid, no-risk alternatives to money market accounts. Thousands of people may have lost access to their funds because of the fallout surrounding these complex securities, according to Bond specialist Eric Jacobson of Morningstar.
When Flo Purnell sold her house in Washington, D.C., a couple of years ago, she needed to safeguard the proceeds, which were close to $350,000. Purnell, who worked for a time at NPR, was planning to move across the country in the future.
"I wanted to put the money someplace that would be accessible," Purnell says. "But I wanted a little bit more interest. I wanted something that made sense."
Advice to Buy
After talking with her financial adviser at Smith Barney, Purnell bought some auction-rate securities that were issued by a mutual fund. She got a slightly higher interest rate than she might have earned in a money market fund. And she thought she could sell at any time. Ordinarily, the securities are traded at weekly or monthly auctions.
As planned, Purnell moved to Los Angeles and found a job with an aerospace company. Earlier this month, she entered a contract to buy a house. But when she went to cash in her securities for the down payment, her adviser told her she couldn't get her money out.
"I was really blindsided by this," she says. "I wasn't hearing anything beyond, 'I can't do it. I can't execute the transaction.'"
Purnell is not the only one who suddenly learned that a big chunk of her savings can't be touched.
"Unfortunately, her situation is one that we're seeing playing out across the country," says Karen Tyler, who heads the North American Securities Administrators Association, an association of state securities regulators. The association has fielded hundreds of complaints from people in the same situation.
Investors were able to buy auction-rate securities with as little as $25,000, she explains. "So this is definitely a Main Street America problem. We have the young couple whose home purchase down payment is tied up. We have the farmer whose spring planting is tied up, [and] the small business owner whose operating capital is tied up."
State regulators are looking into whether investors in auction-rate securities received adequate warning that they might have difficulty liquidating their investments.
A spokesman for Smith Barney couldn't comment on Purnell's case. But he says the company is actively supporting industry efforts to resolve the problem.
The meltdown of the auction market in February caught many people by surprise. Jacobson says for years, auction-rate securities worked pretty much as advertised. There were plenty of buyers at the regular auctions, and if there weren't, the Wall Street banks would buy the securities themselves.
But in February, Wall Street's battered investment banks could no longer afford to buy unwanted auction-rate securities. And with the value of many other securities suddenly in doubt, Jacobson says individual investors got cold feet.
"They just wanted to get away from anything that seemed to have the least bit of risk. Those things just kind of feed on themselves," Jacobson says. "Once there's a little blood in the water, everything starts to swirl."
The securities are still backed by real assets, and they're still paying interest. But that's cold comfort to someone like Purnell, who can't sell when she wants to. Morningstar's Jacobson says it's a reminder that liquidity can be an ephemeral thing.
Jacobson expects that the companies and government agencies that issued the securities will eventually buy them back from investors. In the meantime, Smith Barney's parent company, Citigroup, has offered to lend Purnell half the value of her securities so she can complete her house purchase.