No Security in Securities

James Stewart is shocked – shocked! – to find out that his ARPS aren’t liquid.

They were sold as a liquid, safe, slightly higher-yielding, tax-exempt alternative to money-market funds. I should know, since I bought some…

What was a ready source of cash is now essentially frozen.

Last year, when some money-market funds turned out to hold some mortgage-backed securities and faced a liquidity crisis, their sponsors stepped in and redeemed the shares at face value. This seemed the only decent course, not to mention a good investment in customer loyalty.

But when I asked a broker at Merrill Lynch if it would do the same for owners of these money-market equivalents, the answer was "no" — not after the multibillion-dollar write-offs Merrill has taken on illiquid assets. Merrill Lynch and the other big banks that sold these shares have stopped making a market in them, which is a major reason the auctions have failed.

Merrill Lynch, when asked for comment, told me: "We are offering our clients loans which can give them liquidity." It wasn’t yet clear whether these would be interest-free loans, which they certainly should be, in my opinion…

In my view, any failure of the big banks to honor what is at least a moral commitment to the people to whom they sold these shares is appalling.

My sympathy for Mr Stewart is, I must admit, limited. ARPS are auction-rate preferred shares: yes, that’s shares, as in stocks, as in equities. When you buy these things, you’re buying equity in a closed-end fund which invests in auction-rate bonds. And any investment in a closed-end fund carries risks: not only liquidity risk, but also the risk that you won’t be able to get a bid near the fund’s net asset value.

When Stewart bought his ARPS, they were liquid and tax exempt and (ahem) "slightly higher-yielding" than money-market funds. Did he think that excess return carried no risk? There was a lovely merry-go-round, in which the likes of Merrill Lynch would make enough fee income from structuring these products that they were happy to support the auction-rate bonds. But when the monolines started looking fragile and the banks started needing all the liquidity they had for other purposes, they threw in the towel.

Stewart asks what’s safe, these days:

So is any fixed-income security short of U.S. Treasurys and the biggest, most liquid money-market funds safe at this point?

The answer is that if you want your money back on demand, you shouldn’t be buying securities at all, you should be buying demand deposits – placing your money in some kind of interest-bearing checking account. Securities always have a bid-offer spread, and in times of crisis that spread can widen out dramatically. Treasuries are a special and unique case, which is one reason why a lot of risk-averse individuals give up a bit of extra yield and sleep well at night with their money in nothing but Treasury bills.

The minute you diversify out of Treasury bills, you’re taking on risk for the sake of extra returns. If you end up running into a market crisis, it’s a bit rich to start blaming your broker.

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