Broken securities market draws fire

"Cash is king." That's the adage during turbulent times in the investment industry.

And cash is what a lot of individual and corporate investors wish they had instead of "auction-rate securities" as a higher-yielding alternative to money-market funds that were earning just 1.5 percent.

Since Feburary, the estimated $330 billion market has been broken, and the funds are frozen.

"There are going to be lawsuits all over," said Jeanette Parr, professional adviser to the investment program at the Carlson School of Management at the University of Minnesota and a onetime bond portfolio manager at Ameriprise Financial Inc. "There are phone calls between clients and brokerages. And if you are a debt issuer, such as a local government or corporation, you can't get at your funds. This illiquid market reflects a lack of confidence among issuers and investors who thought this was a risk-free investment that resets all the time."

New York Attorney General Andrew Cuomo has launched an investigation, demanding documents from 18 institutions, including Merrill Lynch and Goldman Sachs. On Thursday, a multistate task force of securities regulators launched another probe of how the auctions were run, why broker-dealers stopped supporting them with their own bids last winter, and how they were sold to consumers who believed they were buying a safe and easily sold investment. Cities, suburban school districts and corporations borrowed for long periods at lower, short-term interest rates because the rates reset weekly or monthly in a bidding process conducted by securities dealers. The market virtually collapsed when many dealers chose to stop supporting the auctions with their own bids for the paper. Investors who sought extra yield in what they believed was a cash-like, or liquid, security, are now stuck with securities they can't sell.

In recent days, companies such as Best Buy, ADC Telecommunications and others have taken write-downs of up to 50 percent on their dead-in-the-water auction-rate portfolios.

Lakes Entertainment Inc. of Minnetonka said it bought its $53.5 million in the securities from huge UBS Securities, which this week agreed to lend Lakes up to $11 million against the securities to meet the company's cash needs.

In a prepared statement, Wells Fargo said, "The industry is dealing with difficult challenges caused by unprecedented events the past few months in the auction-rate market. ... We're doing what we can to support our customers who hold these securities."

Piper Jaffray declined to comment Thursday about what could prove to be a lawyers' holiday.

"We are in the first act of the dance of a thousand veils," said Terry Fruth, a veteran securities lawyer who is meeting with prospective clients and other lawyers. "One thing these auction-rate securities are not: a money-market sort of fund."

Auction-rate securities are debt or preferred stock, backed by student loans, municipal debt, mortgages and other long-term obligations. The auctions were largely managed and supported by broker-dealers and sold to customers. Some of the offering statements should win thumbs-down awards for opaque writing by lawyers in service to the financial industry.

What caused the market to freeze? After the crash of the subprime mortgage market, fear has so overwhelmed the marketplace that few want to own anything beyond plain-vanilla government or corporate bonds.

In May 2006, the SEC censured and fined 15 securities firms, including Piper and the former RBC Dain Rauscher, for peddling auction-rate securities that "had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers," in addition to several other "misstatements and omissions" in violation of securities law.

"I think that clients, large and small, have been surprised by how the large investment banks have not taken responsibility, stood up and made the market for the [auction-rate] securities," said Ty Schlobohm, managing director of the investment management group at Cherry Tree Companies in Minnetonka. George Hicks, a veteran at Varde Partners, the Edina-based fund that buys distressed debt, said he and other hedge funds have been sniffing around some auction-rate portfolios.

The Wall Street houses and banks want to minimize more capital-eating write-offs. Some are lending to their customers and letting them use the auction-rate securities as collateral.

"This all points to a prolonged recession in the financial sector," said Parr, of the Carlson School. "There's fear and uncertainty. And we continue to get bad news."