Investors Caught in ‘Wonderland’

Christine Gray, a knowledgeable investor who lives in New York, will have to borrow money from her broker to pay her taxes April 15. It’s not that she didn’t plan carefully or doesn’t have the resources: She is unable to get access to her account for the cash she needs.While her broker, Merrill Lynch, has long described her holdings as “money market equivalents,” her investments in so-called resets are now illiquid. Ms. Gray is not alone, as thousands of Americans preparing for tax day may find themselves caught in another “Alice in Wonderland” excursion into the credit markets.For years, with the advice of her broker, Ms. Gray has kept cash balances invested in these resets, typically long-term tax-exempt bonds that pay rates that vary from week to week. The rate charged at agreed-upon intervals — usually seven, 28, or 35 days — is determined through an auction. Bidders for the paper determine the rate that will be paid. The frequent resetting of the rate allows the issuer to pay lower rates than would apply to a straight long-term bond, while the investor, in turn, picks up incremental yield over normal money-market instruments.In the past several weeks, the market for these resets, also known as auction rate securities, has come unglued. Only 15% to 20% of the reset auctions have succeeded as bidders balk at buying them, and the investment banks are refusing to support the market.In the case of Ms. Gray, her broker has attempted to sell her investments for several consecutive weeks, but there have been no takers. Merrill Lynch has proposed making a loan to tide her over, allowing the reset market to right itself. She is not thrilled.Individuals such as Ms. Gray are not the only sufferers from the collapse of the reset markets.The issuing institutions, many of them with excellent balance sheets and credit ratings, have found themselves suddenly paying ridiculously high rates. In one outstanding example, the Port Authority of New York and New Jersey saw rates rise to an absurd 20% from just more than 4% the week before. The New York Sun ran a story yesterday about the impact of the reset failures on CUNY; others include Fordham University and the Metropolitan Museum of Art.A market source says the dealer community is working with issuers to reconfigure their debt strategies. In some cases, the clients will call the reset bonds and issue long-term securities as replacements, which will likely cost them more. In addition, they will be providing the banks with extra fees. A little salt in the wound.While there may be some solutions, borrowers and investors such as Ms. Gray are questioning why the investment banks have abandoned their support of the $300 billion reset market, leaving clients high and dry.In the past, the investment banks that have helped municipalities and other tax-exempt institutions raise money through these reset bonds have conducted the auctions that determined the issues’ weekly or monthly interest rates. The banks have also typically stepped in to support the prices of these highly rated securities. That is no longer the case. As Matt Fabian of Municipal Market Advisors says: “The banks have always acted to stabilize the market, which is an appropriate role. In the last few weeks that has changed.”Numerous factors have driven the firms from the marketplace. Accounting changes and worries about weakened bond insurers began to unsettle the reset market late last year. As reported by Dealbreaker, an advisory issued in January by the accounting firm Deloitte raised alarms about the deterioration in reset products, causing corporate buyers to shy away from further commitments. Simultaneously, the municipal bond market was roiled by concerns about the creditworthiness of bond insurers such as Ambac Financial Group Inc. and MBIA Inc. As a consequence, the investment banks found themselves committing ever greater resources to support the auctions, according to one market source, straining their balance sheets and exposing them to possible costly write-downs. Some banks also instituted new risk-management guidelines that constrained commitments, leading to widespread auction failures.This is not an academic problem. This is a problem that raises costs for schools, cities, hospitals, and taxpayers. It is also a problem for those who hold the paper.A manager at Merrill Lynch, who would not comment for attribution, says the firm’s traders initiated its exit from the reset market. “Up until two or three weeks ago we were still putting this paper in individual accounts,” he says. “Then suddenly, the trading floor sent word that it was no longer suitable, and that we should get out. The business disappeared within two to three days.”Merrill Lynch is not alone with this scenario. Mr. Fabian says: “Wall Street acts like a herd. The market is going to go away; at best it will be a fraction of itself.”A spokesman for Merrill Lynch said, in response to the bank’s manager: “The person who anonymously offered an opinion on suitability does not speak for the firm. Whether an investment is suitable depends on questions about specific investments and all the facts and circumstances for a specific client.”Merrill’s withdrawal from the reset market is symptomatic of a major change in how the company is addressing risk management, according to a person who has been with the company for many years, who says: “Everyone is trying to find ways to diminish exposure.”The firm has reconfigured its risk-management apparatus to give overseers a broader perspective. A former CEO who wanted to take more aggressive positions, Stanley O’Neal, organized the risk-management function by product line. These “product silos” have now been broken up, and responsibility is today shared by a committee representing the firm’s many lines of products.The upshot may be better perspective, but it can also result in paralysis. Managers of one area feel less confidant of the issues confronting another, and so are less willing to back commitments. It is not only Merrill Lynch that has made this kind of change. Lehman and Morgan Stanley have apparently made similar moves.It is not surprising that the investment banks have circled their wagons. Their balance sheets are under stress and they may still face more write-downs. It is unfortunate, however, that the cure appears almost as painful as the disease. It is also unfortunate that the number of people paying the price for earlier carelessness continues to grow.peek10021@aol.com

Investors Caught in ‘Wonderland’

More from the New York Sun

A Tale of Two Harvards

A Japanese Defense Buildup Could Form a Regional Counterweight to Communist China

Belichick’s Hall of Fame Snub Exposes the NFL’s Uncomfortable Cheating Debate

More from the New York Sun

A Tale of Two Harvards

A Japanese Defense Buildup Could Form a Regional Counterweight to Communist China

Belichick’s Hall of Fame Snub Exposes the NFL’s Uncomfortable Cheating Debate

U.S. Borrows Itself Into a Corner

US Military Catches Sanctioned Oil Tanker in Indian Ocean Weeks After It Left Venezuela

King Charles Pledges ‘Support’ for Police Investigation Into Andrew Mountbatten-Windsor

Families of Druze Children Killed in Hezbollah Rocket Attack on Soccer Field Sue Terror Group for $26 Million

Trump Aims for Win in Stormy Daniels Case: Will Appeals Court Overrule Judge, 92, Who Refuses To Move Prosecution to Federal Court?