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Investing May 22, 2008, 5:00PM EST

Auction-Rate Securities: How to Get Unstuck

(page 2 of 2)

Illustration by Shout

Instead, he was redirected to the bank's brokerage representative, who offered a higher-yielding alternative: auction-rate securities.

Cohen says he told the rep he was on a fixed disability income and needed access to the money frequently for tuition and other expenses. The rep never explained about the auction process, he says. Cohen has been unable to liquidate the securities since February. In May, he filed an arbitration action with the Financial Industry Regulatory Authority, or FINRA. Justin Gioia, a Wachovia spokesman, says the bank won't discuss individual customers.

Cohen says he never received a prospectus, nor apparently did the vast majority of auction-rate security investors. Securities law requires only that a prospectus be provided when new securities are issued; buying at a periodic auction is technically a secondary market purchase.

Investors say that miscommunications from their brokers are aggravating the problem. Wachovia lent Cohen $11,000 against one of his securities, which were issued in $25,000 chunks, but when the Nuveen fund that issued the securities bought back some shares in April, the bank used the first portion to pay off that $11,000 loan immediately. Cohen was surprised to get only $14,000 in cash and is still stuck for more than $75,000 in his account. A new loan was offered at over 7%, more than double the 3.1% the securities now yield.

Nuveen redeemed about 36% of the fund Cohen is in, but he complains he had only 25% of his holdings unfrozen. A Houston investor who owns about $1 million in auction-rate securities, mainly issued by the Calamos Strategic Total Return Fund, had a better experience, after some confusion. The investor, who declined to be named for privacy reasons, was paid 80% of his holdings after Calamos redeemed 81.5% of the securities the week of May 12. When he first heard about the redemption he was outraged, however, because he says his broker told him he'd get 8% redeemed, not 80%. "Their inability to provide clear information just adds insult to injury," he says.

DISTRIBUTION DISCONTENT

Calamos and Nuveen say they can't dictate how money is distributed when they conduct partial redemptions. "We can't control that process," says Ken Fincher, Calamos' director of product management. "I'm telling people to make it known to their broker that they want to be redeemed. If you raise your hand, you might be first and foremost."

The actual allocations start with the Depository Trust & Clearing Corp., the industry- owned clearing and settlement giant that maintains lists of all securities holders and doles out the money in a lottery process. Under the DTCC approach, funds are distributed randomly to each firm that has customers who own the securities being redeemed. Then each firm uses its own process for divvying up money between customers.

Many firms say that they are following a process similar to the DTCC, but none will reveal their exact methodology. "Currently, client shares are called as determined by a random and impartial lottery," says Alexander Samuelson, a spokesman for Citigroup's (C) Smith Barney brokerage. Other companies won't say anything. Spokesmen for Merrill Lynch (MER), Bank of America (BOA), and UBS (UBS) all declined to comment on the allocation of funds from redemptions. FINRA issued a notice on Apr. 30 to companies urging them to develop systems that are fair to all investors, according to John M. Gannon, FINRA's senior vice-president for investor education.

The incipient secondary market for auction-rate securities may be another source of frustration. A firm in New York called Restricted Stock Partners, along with Fieldstone Capital Group, a New York brokerage firm, are offering to facilitate sales at discounts ranging from 5% to 20% or more. (Restricted Stock Partners charges sellers a transaction fee of 1% when a trade is completed.) But when John Tierney, a retired lawyer in Jupiter, Fla., asked his Smith Barney broker to check prices so he could sell at either firm, Tierney claims the broker said the firm couldn't trade with them. "I'm very angry, and I'm getting very cynical," he says.

Barry Silbert, president of Restricted Stock Partners, says individuals can bypass brokers and set up accounts with his firm to sell, though they aren't allowed to buy. Smith Barney says that "we do not prevent anyone from selling their securities or otherwise moving them from Citi. We do urge clients to understand the price transparency of any secondary market."

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Calls for Wall Street to Act

Wall Street gets fees tied to the auctions that are supposed to reset rates on auction-rate securities, but 70% of the weekly events fail, wrote Gretchen Morgenson in The New York Times (NYT) on May 4. They also earn fees as municipal issuers redeem the debt and "should stop billing issuers for failed auctions and should recommend that they redeem securities at fair value in the marketplace," she wrote. Smart Money's James B. Stewart, who found himself stuck in a type of auction-rate security, says Wall Street needs to be more responsive to clients. "Wall Street's silence has been deafening," Stewart wrote in a May 1 article.

Pressman is a correspondent in BusinessWeek's Boston bureau .

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