An auction rate security generally refers to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through periodic auctions. It allows issuers to borrow for the long-term but at lower, short-term interest rates.
The auction-rate securities market involved investors buying and selling instruments that resembled corporate debt whose interest rates were reset at regular auctions, some as frequently as once a week. They were sold as being safe as cash.
Over the years, auction-rate securities became popular among investors looking for cash-like options with slightly higher yields than money-market funds and certificates of deposit. The investments—in reality, long-term bonds—were considered more like short-term debt because they could usually be sold at weekly or monthly auctions.
In August 2007, investors began pulling out of the auction-rate-securities market. It seized up earlier this year when Wall Street firms who kept auctions from failing by stepping in to buy any unpurchased securities stopped supporting the market en masse, leaving millions of investors without access to investments they believed were nearly as liquid as cash. Tens of thousands of investors nationwide — including institutional and individual investors, cities and towns, charities and small businesses — were left holding damaged, illiquid securities when the market collapsed.
The U.S. Justice Department is now ramping up criminal investigations into the collapse of the auction rate securities market. Federal prosecutors in Brooklyn,New York , are looking at whether Lehman Brothers Holdings Inc. defrauded its clients by dumping auction-rate securities into their accounts before the market broke down despite knowing the market could collapse. The prosecutors are probing Lehman’s handling of investments for two brothers, Brian Maher and Basil Maher. The brothers sold their family’s billion-dollar shipping business and invested some of the proceeds with Lehman. They lost access to $286 million that was tied up in the securities when the auction-rate market collapsed. Another issue being probed is whether the firm used clients’ money to purchase the securities to prop up auctions that might otherwise fail.
Federal Prosecutors are also probing the role of UBS employee David Shulman to decide whether to charge him with insider trading for selling his own holdings of auction-rate securities ahead of that market’s collapse. Shulman ran the auction rate securities business for UBS. As the credit crisis began to scare away buyers for many types of securities, UBS began to buy up the securities so that the auctions, which the firm ran, wouldn’t fail. Shulman was under pressure from UBS executives to reduce the firm’s holdings of the product, and he allegedly helped mobilize UBS brokers to sell more of the securities to customers as safe cash alternatives, despite his knowledge that the market may not hold up. Around the same time, Shulman sold more than $6 million of his own inventory of auction rate securities.
So far, most investigations have been about the role played by institutions and banks. These investigations are among the first to look at whether individuals committed crimes as the market collapsed in the credit crisis – a step in the right direction.
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