How Not to Make Money

What happens if your basement is flooded? No problem. You turn to your reserve fund – only it is a problem, because, although you have thousands in reserves, you find you can’t immediately get at your money because it’s been invested in auction rate securities (ARS). Huh? What happened to T-bills? More importantly, what’s a board to do?

It happens like this: smart co-op.condo boards are always looking for ways to put their reserve funds to work. As a rule, this means making investments that offer low risk, a reasonable return, and the chance to get at the money if any unexpected expenses should arise.

Since its inception in the late 1980s, the $330 billion auction rate securities (ARS) market has become an attractive place for some of the city’s co-op and condo boards to invest. These are long-term bonds that hospitals, cities, corporations, and mutual funds sell at weekly or monthly auctions. Returns have historically been healthy. And since investors can buy, sell, or hold the securities at any regularly scheduled auction, many investors treated them as liquid cash investments.

Then along came the credit crisis. In February, some cash-strapped investment banks stopped propping up auctions. When sellers of auction rate securities couldn’t find buyers, the once-reliable auctions began failing and the investments became, in accountant lingo, “illiquid.” As some co-op.condo boards found, to their surprise and dismay, ARS, unlike treasury bills or certificates of deposit, do not have guaranteed liquidity.

In February, a lower East Side co-op board in Manhattan found itself caught in this unpleasant bind – unable to gain access to its $2 million reserve fund, which a broker at Merrill Lynch had invested in a single auction rate security without bothering to inform the board. One week after the broker made the unauthorized investment, auctions started failing – and the co-op discovered that its investment was frozen.

“Merrill Lynch put this building’s money into one fund just before the market crashed – without our knowledge or approval,” says the co-op’s property manager, Ellen Kornfeld vice president at the Lovett Group of Real Estate Companies.

The co-op has since retrieved roughly $700,000 of that through successful auctions. Although the remaining $1.3 could not be immediately liquidated, it still draws interest.

The situation has made Kornfeld wary of the ARS market. “I would say to a board, stick with treasury bills and certificates of deposit,” she says. “And never put more than $100,000 – which is what’s insured – in any one investment. I always advise boards to be conservative.”

So does Abe Kleiman, an accountant with Kleiman & Weinshank, which keeps the books for some 200 co-ops and condos in the city. Kleiman strongly advises his clients to steer clear of such investments as auction rate securities, where higher potential returns are accompanied by greater risk. “I always advise a co-op or condo that it should not invest in anything but treasury bills or certificates of deposit,” he says. “Forget the stock market, forget the bond market, forget mutual funds. They’re too volatile. Boards should be taking zero risk. That reserve fund is for a rainy day or a large capital expenditure.”

Attorney James Samson, a partner at Samson, Fink & Dubow who represents the East Side co-op, says the problem is twofold. First, boards should not be making risky investments; and second, they should not give property managers, brokers, lawyers, or anyone else the power to invest their reserve funds for them.

“Never do it,” he advises. “No managing agent or anyone else but the board should have signatory power. It’s never worth it. And you should never invest in anything that puts the principal at risk. This is a cautionary tale. You always have idiots who think they can earn a few more points in interest. It’s the same reason banks go under.”

Samson has written angry letters to Merrill Lynch on behalf of the co-op, and he has alerted the state attorney general’s office about the investment. But beyond that, he says, he has little legal recourse.

“The board keeps yelling at me to sue,” he says, “but they haven’t actually lost any money yet. Where are the damages? They’re lucky they don’t need the money right now.”

The sense of anger and frustration reaches beyond this one co-op, however. “There are a lot of angry people out there because they were never told that if the market-makers stopped making the market, their money would be frozen,” Samson says.

Kornfeld, the property manager, agrees that banks and brokers have been less than straightforward about the risks of auction rate securities. “Most of the brokers presented these as liquid investments,” she says. “Any board that chose such an investment did not get the sense that there could be a problem with liquidity.”

In July, New York State Attorney General Andrew Cuomo brought a multi-billion dollar nationwide lawsuit against the Swiss banking giant UBS for allegedly pushing investors into buying troubled auction rate securities at a time when the bank’s top executives were selling $21 million worth of their personal ARS investments. UBS has denied wrongdoing.

Meanwhile, the state of Massachusetts sued Merrill Lynch & Co. for “dishonest and unethical” conduct when it created a marketing scheme that authorities say significantly misstated the nature and stability of the ARS market.

On August 7, Merrill Lynch offered to buy back $10 billion worth of auction rate securities from individual investors, and Citigroup agreed to buy back $7.3 billion worth and pay $100,000 in fines. Merrill Lynch will begin buying back auction rate securities that can’t find a buyer at auction, beginning no later than January 2009. For the East Side board, that’s good news.

“They’re not going to lose a dime,” says Mitch Unger, controller for Lovett. “In fact, they’ve been receiving interest since the auction failed in February. This was a learning process for everybody.”

Several co-op.condo board members who invested their reserve funds in auction rate securities declined requests to be interviewed. Says one, speaking through the cooperative’s accountant: “I don’t want our co-op to be seen as a poster boy for bad investments.”