NYT: Did Chuck Do His Job?
Today’s Times editorial focuses on Charles Schwab’s attempt to avoid repurchasing millions of dollars in auction rate securities from their investors. I do not have a definite opinion on this specific topic since I do not know exactly how Schwab investment advisors may have presented the investments.
What I do see this as is another fantastic example of an attempt to offload personal and professional responsibility onto someone else. If it weren’t for competition from the likes of CDOs and subprime mortgages, auction rate securities could have been the poster child for excess and irresponsibility in structured finance.
Although I had heard about auction rate securities many times in my career as an institutional investor, I never had reason to give them any more than a cursory glance since they never fit into any of my portfolio strategies. During the crisis, I found myself required to take a much more in-depth look at a portfolio of auction rate securities which, surprise, could not be sold after February of 2008 at anything other than distressed levels. What I saw shocked me.
I’ll skip over all the gory details, but the upshot was that the investor was completely dependent upon a functioning auction market for the “value” of their investment (this is because the auction rate securities were marketed as extremely short term investments, and carried the requisite low interest rates). The failure of the auction market would cause the duration of the investment to greatly increase, driving the value down. Again, please forgive me if I spare you the bond math. Suffice it to say that as long as the auction market functioned, the investors’ low interest rate was considered adequate, but if the auction market failed, that low interest rate would drive the value of the securities down precipitously.
The key to all of this, however, is that the fact that the auctions were voluntary was right up front in the prospectus for the securities. For myself, I couldn’t imagine why anyone would invest in a security with such incredible and completely unpredictable duration risk, but I know that auction rate securities paid a few extra basis points than seemingly equivalent short term investments, and as a result, many investors were tempted into the market.
My only comment is that if one investment which on the surface looks similar to another is cheaper, there is probably a reason. The fact that many people didn’t choose to look for that reason probably isn’t Chuck Schwab’s fault.
