Financial Crisis Special Report: Avoiding Auction-Rate Securities in Reserve Funds

It happens like this: Smart co-op / condo boards always look 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 — i.e., liquidity — if unexpected expenses arise.

Since its inception in the late 1980s, the $330 billion auction-rate securities market has become an attractive place 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 came the credit crisis. In February 2008, some cash-strapped investment banks stopped propping up auctions. When ARS sellers couldn't find buyers, the once-reliable auctions began failing and the investments became, in accountant lingo, "illiquid" —and some boards found, to their surprise and dismay, that ARS, unlike T-bills or CDs, do not have guaranteed liquidity.

Forget the stock market, forget the

bond market, forget mutual funds.

They're too volatile.

That month, a Lower East Side co-op board in Manhattan found itself unable to access its $2 million reserve fund, which a broker at Merrill Lynch had invested in a single ARS — without bothering to inform the board! One week after the broker made this unauthorized investment, auctions started failing — and the co-op discovered its investment was frozen. (It has since retrieved $700,000 through successful auctions, and the remaining $1.3 million, though illiquid, continues to draw interest.)

"Merrill Lynch put this building's money into one fund just before the market crashed — without our knowledge or approval," marvels the co-op's property manager, Ellen Kornfeld of the Lovett Group of Real Estate Companies. "[S]tick with treasury bills and certificates of deposit," she says, adding to never put more than the FDIC-insured amount — $100,000, currently being raised to $250,000 — in any one bank investment.

Abe Kleiman, an accountant with Kleiman & Weinshank, strongly advises his clients to steer clear of ARS, where higher potential returns than with safer investments are accompanied by greater risk. "[You] 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 make risky investments; and second, they should not give property managers, investment 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."

Never give anyone else the power

to invest your reserve fund for you.

Compounding the problem is that banks and brokers have been less than straightforward about the risks of ARS. "Most of the brokers presented these as liquid investments," Kornfeld says. "Any board that chose such an investment did not get the sense that there could be a problem with liquidity."

In July 2008, New York State Attorney General Andrew Cuomo brought a multibillion-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 off $21 million of their personal ARS investments. 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 ARS from individual investors, and Citigroup agreed to buy back $7.3 billion worth and pay $100,000 in fines. Merrill Lynch, beginning no later than January 2009, will begin buying back ARS that can't find a buyer at auction

For the East Side board, that's good news. "They're not going to lose a dime," says Mitch Unger, controller for Lovett. "This was a learning process for everybody."

Adapted from Habitat October 2008. For the complete article and more, join our Archive >>