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What’s the Definition of “Safe?”
By JLP | February 14, 2008
This is unbelievable.
From Debt Crisis Hits a Dynasty ($) in today’s Wall Street Journal:
When M. Brian and Basil Maher sold their family’s shipping business last July for more than $1 billion, they quickly put the money in a safe place.
Or so they thought.
The two brothers handed much of it to Lehman Brothers Holdings Inc. with marching orders to make only the most conservative, cashlike investments. Within weeks, however, they had lost access to more than a quarter-billion dollars.
“We didn’t think we were taking risks,” says Brian Maher, 61 years old. “We read about all the troubles in the credit markets and said, ‘I’m glad we’re not invested in that stuff.’ It turns out, we were.”
The Mahers rank among the earliest victims of “auction rate” securities, a once-obscure type of bond now sending shock waves through broad swaths of the U.S. economy. Auction-rate securities—an unusual type of long-term bond that behaves like a short-term bond—have become a keystone of modern finance. They are routinely used to fund everything from college student-loan programs to municipal road-and-bridge projects.
Later, the article goes onto explain auction-rate securities in more detail:
Auction-rate securities usually are long-term bonds with interest rates that are reset periodically (usually once a month) at an auction. Because the auctions happen so often, the bonds traditionally were much easier to buy and sell than other forms of long-term debt. Auction-rate securities worked well for over 20 years and were regarded by Wall Street as cashlike investments, since they were highly liquid and highly rated.
But if buyers stop showing up for auctions, they become tough to sell, or even to value.
So, action-rate securities were believed to be highly liquid and highly rated. But, were they safe? NOPE!
From reading the article, it appears the brothers did everything right:
Mr. Liu [their advisor] and the Mahers drew up a basic list of financial objectives. The first one, according to a letter the family sent the banks: “Preserve capital.” The second was to “provide sufficient liquidity” and third was “capture a market rate of return based on [the brothers'] investment policy parameters and market conditions.”
The brothers are trying to get their money back from Lehman. Lehman of course, doesn’t want to pay it back. I can see both sides of this issue. From the article, it sounds like Lehman was doing what they were supposed to do. But, did they have a responsibility to see that the auction-rate securities were not safe?
Opinions? If you would like to read the entire article but don’t have a WSJ subscription, let me know and I’ll email you a copy of the story. I think the WSJ will allow me to mail out 5 copies so it’s first-come-first-serve.
Topics: Miscellaneous |
February 14th, 2008 at 2:10 pm
I think you’re being rather harsh with the “Were they safe? NOPE!” It’s easy to criticize investment in auction-rate securities in hindsight, but this situation was caused by the credit crisis and also different from the credit crisis.
Auction-rate securities are securities where rates are set in dutch auctions. Usually there’d be nearly as many sellers as buyers. The financial institutions that run the auctions generally buy the excess supply (thus putting debt on their balance sheets). It was, until now, very unusual for auctions to fail.
The problem is that a lot of these securities are insured by bond insurers like Ambac and MBIA. Because of these insurers’ involvement in the mortgage crisis, they are on the verge of credit rating downgrades. This makes borrowers more wary of other securities insured by the insurers, including, for example, student loans that are often sold through auctions.
Absent of a credit crisis, auction-rate securities are in fact fairly safe. However, due to the credit crisis, people no longer want to put even credit-worthy debt on their balance sheets. This decreases the number of buyers at auction. But this also means Wall Street firms running the auctions are less able to simply buy the excess - because this means putting unsellable debt on their balance sheets.
This is unlike the basis of the credit crisis itself, though. Subprime mortgages were essentially “junk” debt, repackaged and rated “safe” by ratings agencies that didn’t look at the underlying securities. Auction-rate securities, though, are more like (almost) innocent bystanders - good debt branded as bad debt through guilt by association.
So, again, it’s easy to say that Lehman had a responsibility to realize that auction-rate securities were unsafe, now that we know a credit crisis can cause auctions to fail. But that’s like saying a massive depression leading to a run on the banks means bank deposits are unsafe. This is a black swan - something that no one could have foreseen before the credit crisis really started rolling.
By the way, I wouldn’t let the Maher brothers off easy. Isn’t one of the cardinal rules of investing that you should never put your money into securities you can’t understand? If they wanted “conservative, cashlike investments,” they should have gone for TIPS or even an MMA.
February 14th, 2008 at 4:08 pm
Municipal reset bonds are a good deal as long as there are buyers. I invested in these too, but got out last December when news broke that credit downgrades of the insurers were imminent.
I would like to read the entire article. If possible, can you email me a copy? Thanks.
February 14th, 2008 at 5:12 pm
Oh no! They only have $750 million left! How will they survive in retirement now!
February 14th, 2008 at 5:15 pm
Toby,
That’s not the point. The point is that they thought they were in something safe, when in reality, they weren’t.
February 14th, 2008 at 9:40 pm
They currently aren’t liquid, but they are still getting paid 6% on the $287 million.
February 14th, 2008 at 10:35 pm
Paul is exactly right. Michael Kim, the Mahers’ lawyer, is spinning a sound byte when he says, “As far as I’m concerned, if we can’t get the money out, and we can’t sell them, that’s a loss.” It isn’t a loss, except a loss in liquidity. The Mahers still have bonds, except the bonds have no buyers. What does this mean? When the bonds mature, the bond issuers will still pay them back their principle; in the mean time, the bond issuers are sending them coupon (interest) payments.
If, like some other auction-rate securities, the bonds increase in yields (like Port Authority’s 20% yield), then the issuers will likely restructure their capital structure, at which point they’ll still pay back the Mahers. Until then the Mahers will earn the higher yield on the bonds they hold.
This is actually a win-win situation for the Mahers unless they need the money right now, and given that they still have $750MM elsewhere, I don’t think that’s a problem.
The only way that the auction-rate securities they bought aren’t “safe” would be if the underlying bond issuers are not credit-worthy. But that’s unlikely to be the case if the issuances are munis (the most common auction-rate securities) or even repackaged student loan debt. I guess Lehman could have put the Mahers’ money into some exotic debts, but the article doesn’t make that clear.
Finally, the last bit in the article about companies like 3M, US Airways, and Bristol-Meyers Squibb taking writedowns on auction-rate security is a bit misleading. There’s a strong possibility that these companies are writing down their debt to claim a tax benefit in the current year or to boost earnings growth the next year, when there is no such writedown. I’m not certain of the motivation behind the writedowns - but this was the first thing I thought of.
February 14th, 2008 at 10:38 pm
I amend my comment: Apparently the Mahers’ securities were in subprime.
But since the majority of auction-rate securities are backed by munis, I still think my thesis is correct: blame subprime (or the relevant underlying securities) for “unsafeness,” not the auction process or auction-rate securities in general.
And I still think the Mahers should have taken a little time to understand their investments, even if they were paying other people to run their money.
February 14th, 2008 at 11:16 pm
Pretty tough situation. It’s hard to see who’s at fault (if any) without seeing the exact guidelines they written up or agreed to. As Lehman said, they checked off the list of 12 types of investment vehicles… Lily does have a point too in that they couldn’t have foreseen this.
I get what you’re saying though JLP, they thought they were parking them at a safe place, until they can setup their own wealth managers to take care of the money… and I suppose in hindsight they should have asked Mr.Liu to find a “professional investment consultant” as Lehman Bros. put it.
Imagine if they had went w/ only Lehman..
February 15th, 2008 at 12:18 am
It’s hard to have pity on mega-rich folks who don’t take the time to know where their money is or what’s going on with it. Never assume your broker can’t lose your money; assume that he or she will and make sure that you agree with and understand every investment that is made on your behalf. It’s your money after all. Not knowing to me is like not caring. And it’s probably true. If you are so rich that you can turn over a billion dollars to your broker, $250 million may not mean much to you.-Rich
February 15th, 2008 at 9:34 am
Unfortunately, this is an expensive lesson for the Maher’s not to trust anyone else to do the right thing with your money (especially not a “respectable” brokerage firm - hah!) Now they’re going to waste hundreds of thousands of dollars (if not millions) in legal fees trying to get the money back in a legal system that is rigged in favor of the brokerage firm (I speak from experience). Good luck to them.
February 15th, 2008 at 2:46 pm
Wow…I just read yesterday about how buyers are backing off and liquidity is quite an issue.
Thanks for putting this out. Can you please email me a copy too? Appreciated!
February 17th, 2008 at 6:59 pm
Auction rate securities are a form of SIVs that were invented by Goldman Sachs in 1988. Yes, the same Goldman Sachs that sold subprime CDOs and then shorted them. Anyone who can get out of financially engineered instruments in this time of imploding CDOs, CLOs, CDSs, SIVs, SIV-lites, CMBSs and Pik-toggle notes, should get out. If you see the word, “enhanced”, run like the wind.
February 17th, 2008 at 10:33 pm
It is frustrating that the investment banks are suddently and indiscriminately deciding not to backstop ANY of the auctions regardless of the quality of the credit. Even if it’s an AAA MUNI insured by FSA, and even if it has an underlying high quality investment grade rating (without factoring in the insurance), the investment banks still aren’t supporting the auctions.
I view it as problematic that the investment banks did not disclose the degree of backstopping that was done in the past. Backstopping is what kept ARS fuctioning as an alternative to money market accounts, because failures virtually neve happened until now. Now that the Investment Backs discontinued that practice, spreads between ARS verses MM are going to be substantially higher than before, even if things settle down, because investors who need short-term access to the cash are no longer able to view them as a money market alternative.
By the way, high grade muni ARS bonds that I own have a Mandatory Tender clause in the offering statement, which means that if two consecutive auctions fail, then they will attempt to remarket the securities as fixed income bonds (and buy back the existing bonds from current holders at par).