Fair
Game
As
Good as Cash, Until It’s Not
By GRETCHEN
MORGENSON
INVESTORS
across the nation are finding themselves in Wall Street’s version of the Hotel
California: they have checked into an investment they can never
leave.
The investments, which
Wall Street peddled as a cash equivalent, are known as auction-rate
notes. They’re debt instruments carrying rates that reset regularly,
usually every week, after auctions overseen by the brokerage firms that
originally sold them. They have long-term maturities or, in fact, no maturity
dates at all.
But
because the notes routinely traded hands at auctions, Wall Street convinced
investors that they were just as good as cold, hard cash.
Lo and behold, the $330
billion market for auction-rate notes ground to a halt in mid-February when bids
for the securities disappeared. Investors who thought they could sell
their holdings easily are now stuck with them. It turns out that the only thing
that’s really just as good as cash is, well, cash.
While
investors pray for a resurrection in the auction market, they are receiving a
fixed interest rate outlined in offering documents. Historically, these
securities have paid approximately one percentage point more than money market
funds. Many purchasers of these notes are relatively small individual investors;
several years ago, banks dropped the minimum investment in them to $25,000 from
$250,000.
Municipalities
and other tax-exempt institutions have issued most of the current crop of
auction-rate notes. But closed-end mutual funds issued $65 billion worth. Such
borrowings provide leverage to the funds, letting them generate slightly higher
yields for their common stockholders.
Closed-end
funds that issue auction-rate notes typically sell them in amounts worth
one-third the value of their underlying assets. For example, the John Hancock
Tax-Advantaged Dividend Income fund, with $1.17 billion in assets, has issued
$380 million in auction-rate notes.
Owners of
notes issued by closed-end funds are faring far worse than investors stuck with
municipal issues. That’s because the interest rates paid on municipal notes when
auctions fail are capped at as much as 12 percent, much higher than
the caps on closed-end fund notes, which are currently around 3.25
percent.
In other
words, holders of closed-end fund notes receive little to no premium for being
stranded. Even airlines try to give you a free meal or an upgrade when they
leave you at the gate. Investors are likely to remain in this vise because
closed-end fund issuers have no incentive to redeem their notes since the
interest rates resulting from the failed auctions are so low.
Some
customers who have tried to get their brokers to cash them out say the firms
have responded by offering to let them borrow against the value of these
securities. At a cost, of course: the typical margin rate for borrowers is at
least 7 percent at most shops. Other holders are selling the notes at a deep
discount to speculators willing to buy distressed securities.
Wall
Street made generous fees issuing these securities and running the auctions — as
long as there were bidders. After the bidders vanished, some firms stepped in
and bid for the
securities for a while, giving investors a way out.
No more.
What’s the sense stretching your already-thin balance sheet just to keep a
market open for your customers?
In
interviews, investors who own these securities say they weren’t warned that they
might not be able to sell them if an auction failed. They say they were told
that the instruments were as safe and liquid as — yes, you guessed it —
cash.
Stephen
N. Joffe, a client of UBS Financial Services, is
suing the firm because it put all $1.35 million of his charitable foundation’s
cash into auction-rate securities issued by Eaton Vance Limited Duration
funds. This, even though he said he explicitly told the broker to take no risk
and that he would need constant access to the funds.
Dr. Joffe, 65, is a former
professor of surgery who founded LCA-Vision Inc., a
company that operates laser vision-correction centers. “I never asked my broker
to get me a better rate,” he said. “I felt the responsibility to maintain this
account as a risk-free account. I believed this was in the equivalent of an
overnight money market account.”
Now, the
Joffe Foundation can no longer fund programs that help prevent AIDS in Africa,
provide indigent people with laser vision correction and correct the cleft
palates of African children.
“This was
another hit and run by Wall Street,” said Jacob H. Zamansky, a lawyer in New
York who represents Mr. Joffe. “The banks reaped huge fees on the auctions and
underwriting, then left investors holding the bag.”
UBS
declined to comment.
IN recent days, executives
at several closed-end funds have held conference calls with stricken
investors. But the investors say that none of those funds have offered to redeem
their auction-rate notes. That’s not surprising: their fee structures give them
no incentive to buy out investors.
Unlike no-load
mutual funds, closed-end funds are sold, not bought. They often decline
to prices that are a discount from their net asset values after they are first
offered for sale. One reason for the discount is that it reflects the brokers’
commissions.
But
Arthur D. Lipson, an investor in distressed securities and a principal at
Western Investment LLC, argues that these discounts present an opportunity for
closed-end funds to do the right thing, for both common and preferred
shareholders.
Here is
Mr. Lipson’s solution: Because these funds trade at discounts, he suggests that
their managers sell underlying securities — utility stocks and shares of real
estate investment trusts — and use the proceeds to buy back common shares. This
would shrink the size of the funds and allow them to redeem some of the
preferred shares they issued to increase the fund’s yield.
Managers
hate this idea, Mr. Lipson said, because it would severely reduce the management
fees they receive, based on the assets in the funds. So he has mounted proxy
fights at three funds, seeking board representation to try to force them to
follow his prescription.
The three
funds are John Hancock Tax-Advantaged Dividend Income, which trades at around
7.5 percent less than its net asset value; the Cohen & Steers REIT and
Utility Income fund, trading at a 10.5 percent discount; and Cohen & Steers
Select Utility, which carries a 5 percent discount.
“The
directors of these funds have ignored their responsibilities to the shareholders
and have chosen to protect the managers’ fee income,” Mr. Lipson said. “These
are not operating companies where moms and pops would be out of work. They are
merely financial engineering companies.”
Officials
at the funds contend that Mr. Lipson is a speculator out for a fast buck. They
urge shareholders to vote against him, saying that they have taken steps to
improve fund performance.
As for
the frozen market for auction-rate notes, both fund companies say they are
working with regulators on a solution.
The annual meeting
for shareholders in the John Hancock fund is scheduled for March 31;
shareholders in the two Cohen & Steers funds will vote on Mr. Lipson’s
dissident slate the next day.
That is
about the time that investors will receive their first brokerage statements
reflecting major declines in the value of auction-rate notes. It certainly would
be a happy ending to this mess if closed-end funds were forced to redeem the
notes by selling holdings as Mr. Lipson suggests.
Stay
tuned.