The mortgage meltdown is rippling through the economy inflicting pain on large institutions and small investors alike. The once proud Bear Stearns has been humbled. Almost daily we hear of billion dollar losses from banks and brokerage firms. The average investor is not immune.
The Financial Industry Regulatory Authority ( FINRA ) has just issued an investor alert advising owners of auction rate securities ( ARS ) about what they can do should they not be able to sell those securities. Investors who purchase ARS are typically seeking a cash-like investment that pays a higher yield than money market mutual funds or certificates of deposit. Generally, there are two types of ARS. First, bonds with long-term maturities, typically twenty to thirty years. The second type is preferred shares with a cash dividend.
Auction rate bonds are issued by municipalities, student-loan authorities, museums and many others. Some auction rate bonds, such as those issued by municipalities, may offer certain tax advantages. Auction rate preferred shares are issued by closed-end funds.
Although these are long-term investments, the interest on the bonds and the dividends on the preferred stock shares are variable. Those variable rates are set through auctions for a specific short term. The terms are usually seven, fourteen, twenty-eight or thirty-five days. This is unlike a traditional bond that is issued with an interest rate set for the life of the bond or a preferred stock that specifies the dividend rate for the life of the shares.
These auctions not only set the prices for the ARS but also provide the primary source of liquidity to ARS investors who wish to sell their investment. Many ARS investors treat these securities as a ready source of funds. However, due to the recent developments in the credit market, including downgrades in the credit ratings of bond issuers and bond insurers, a significant number of auctions have failed because there have been more sellers of ARS than buyers. This has left many investors without immediate access to cash.
FINRA advises that ARS investors who want to sell their holdings, but cannot because of failed auctions, have a variety of options available to them. Here are some things they can do:
• Read the ARS offering documents to determine if there are any provisions the issuer has made in case of illiquidity or failed auctions. Some issuers of bonds or preferred shares may have reserved the right to convert the ARS into a fixed or variable rate security or to call the instrument at a certain price.
• Hold on to the ARS until the next auction. However, subsequent auctions might also fail and there is no way to determine when the next successful auction will occur.
• Sell the ARS on the secondary market to a third party. However, selling outside of the auction process might make it harder to determine whether the seller is getting a fair price for his ARS. Also, the seller must add in the costs and fees associated with a transaction completed outside the auction.
• Use margin to meet cash needs. Some firms will lend customers money to help them meet their cash flow needs. This can be risky and costly and is not for everyone.
There are many things to consider before taking out a margin loan. First, the investor should be aware that the interest rate charged on these loans might exceed the yield they are getting on the ARS. Next, if the investor is borrowing against a tax-exempt security this might cause them to lose the ability to deduct from their taxes the interest, or a portion of the interest, on the margin loan.
Most important is what can happen if an investor's account value falls below the margin requirements. The firm has the right to force the sale of securities in the investor's accounts to cover the margin deficiency. If the sale of securities is not enough to meet the margin requirements, the investor is responsible to make up any shortfall. The firm can sell the investor's securities without contacting the investor first. The investor is also not entitled to choose which securities or other assets in their accounts are sold. The firm has the right to choose this. The firm can increase its "house" maintenance margin requirements at any time and is not required to provide the investor with advance notice. These margin increases often take effect quickly and cause additional margin calls. The firm can sell more of the investor's securities if the investor does not bring in additional funds or securities to meet these new margin calls.
• Sell other investments to meet immediate cash needs. The investor should weigh a number of factors before choosing this option. First, the investor must consider the total transaction costs they would incur in liquidating a particular position. For example, the sale of certain class shares of mutual funds or insurance linked products prior to a specific date could incur deferred sales charges or early surrender penalties. Other costs to consider are commissions, fees and mark-downs.
The investor should also consider whether the sale will trigger adverse tax consequences. Withdrawing funds from 401 ( k ) plans, IRA accounts or other tax deferred accounts can generate immediate taxable income and penalties. Also, the sale of securities might incur capital gains taxes.
Finally, the investor should also consider the affect of the sale on their overall portfolio. A large enough sale could make a balanced portfolio unbalanced and not meet the investor's investment objectives.
In these uncertain times, anyone facing these difficult decisions should consult with a financial services professional and an accountant or tax advisor before acting. The fallout from the mortgage meltdown is far from over. Investors, large and small, will be affected in ways yet to be seen.