The most interesting portions of the article, to me, were the relatively new information about this type of securities, and Lehman's suspect actions in putting a client in them.
According to the Journal article,
"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.
These bonds became popular with investors looking for cashlike investments, because they offered better returns than traditional money-market investments but were just as easy to buy and sell.
Recently, however, that advantage has disappeared. The market for auction-rate securities has dried up amid fears about fallout from the subprime-mortgage crisis. This week, New York's Port Authority saw the interest rate on some of its debt jump to 20% from 4.2% amid disruptions in this market."
From what I can deduce from this, auction-rate securities have their interest rates reset by market-auctions, rather than, like a long-term bond, simply carry a fixed or variable, according to some index like LIBOR, rate.
Thus, the price of the securities which, of course, varies inversely with the yield, can plunge if, for some reason, the auction reset results in a very high interest rate being paid to new buyers of the debt. This is evidently what happened to the Maher's Lehman-based holdings.
The Journal article goes on to report,
"The brothers have filed a claim against Lehman, saying it mismanaged their money. The complaint, filed last month with the Financial Industry Regulatory Authority, which resolves disputes between investors and brokers, says Lehman ignored the Mahers' request to put the money in short-term, low-risk investments such as Treasurys and municipal bonds."
According to the Mahers, they didn't realize that Lehman was putting their money into these potentially volatile securities. As the fixed-income markets became increasingly unstable late last year, these securities fell victim to demand simply evaporating, necessitating very high rates of interest to result from the auctions. The Mahers had informal asset management advice from a banker, Mr. Liu, at the firm that sold their business, Greenhill & Co. So abstruse were the instruments that even Mr. Liu didn't fully understand them.
The article continues,
"Baffled by the codes, Mr. Liu says he phoned Lehman and learned that many were corporate auction-rate securities. Mr. Liu, who had only a vague understanding of the securities, asked Lehman for details.
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 we see yet another instance in which investors failed to completely understand that, for some instruments, there is no way a market can be guaranteed to exist continuously. In this case, rather than frequent auctions keeping yields competitive, but leaving the securities reasonably valuable, the lack of risk appetite by buyers has caused rates to skyrocket, correspondingly sending the bond values plummeting.
And, in a page right out of the CDO story, sometimes the bonds can't be valued at all, because the auctions draw no bidders.
Regarding Lehman, the article continues,
"Mr. Liu says he came away from his conversation with Lehman unsure of the quality of the bonds' underlying assets. He consulted with the Mahers, and they agreed the bonds should be sold as soon as possible. Mr. Liu told Lehman to "unwind the positions and give the Mahers their money back."Lehman, however, had trouble selling. In early August, the market for auction-rate securities grew skittish as one auction for lower-grade securities failed.
Lehman had put the Mahers into most of their auction-rate securities a few weeks earlier, in July. It reinvested about $100 million of the Mahers' money in auction-rate securities in mid-August, the Mahers say."
So Lehman, according to the Maher's and their informal advisor, Mr. Liu, failed to invest the Maher's money as directed. Apparently, the Maher's aren't the only investors displeased with Lehman's conduct involving auction-rate securities. The Journal article concludes with the passage,
"Many companies, including 3M and US Airways, are already writing down the value of their auction-rate securities. Bristol-Myers Squibb in January took an impairment charge of $275 million because of auction-rate securities it held.
Merrill Lynch & Co. recently bought back $13.9 million in debt securities that it sold to the city of Springfield, Mass. The Massachusetts secretary of state has since filed a civil lawsuit against Merrill charging the firm with fraud and misrepresentation.
In their claim, the Mahers are demanding their $286 million back from Lehman, along with interest, and are seeking punitive damages of up to an additional $857 million."
Just when you thought you had understood some of the more exotic credit market instruments, this story appears. It turns out that the Port Authority of New York and New Jersey saw its interest rate on auction-rate securities it issued jump to 20% this week, amidst weak investor demand for the notes.
How is it that with so many educated, intelligent investment bankers working in fixed-income departments throughout the industry, instruments such as CDOs and auction-rate debt fail to observe that there are times when demand for such exotic securities evaporates? And current 'values' cannot be easily determined?
If well-compensated, experienced sellers and investors continue to trade these instruments, without realizing all of the risks, can any regulator or government really have an impact on this business?
Or do investors and issuers simply need to experience the pain of loss with these securities, in order to learn not to participate in those markets anymore?