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New trouble brewing as another debt market falters

Investors now refusing to buy US securities regarded not too long ago as safe as cash

NEW YORK – SOME 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 they had considered as safe as cash.

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

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

Only this week, almost 1,000 of these auctions have 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 Mr G. David Mac- Ewen, 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 US$330 billion (S$467.7 billion) auction-rate market is dominated by municipalities and other tax-exempt institutions like the Port Authority of New York and New Jersey, which issued some auction securities and had its interest rate soar to 20 per cent 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 – the ‘fail rate’.

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

The SEC investigation centred 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. Clients who are unable to sell, however, are likely to argue that they were wrongly put into long-term securities when their intention was to buy shorter-term debts.

‘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 Mr Jacob Zamansky, a securities lawyer who represents individual investors.

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.


Source: NEW YORK TIMES (The Straits Times 16 Feb 08)


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