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You may not have heard of the term “auction rate preferred securities.”

Yet.

If you have not, you probably will soon. Essentially, these are longer-term investments but they have an unusual feature: an interest rate that resets – usually every 7, 14, 28 or 45 days.

The “trick” to making this work is having multiple broker-dealers maintaining an orderly auction market. This provides liquidity for sellers to get out (raise cash) and allow buyers to move in. If the broker-dealers walk away from the market, the whole thing collapses like a house of cards.

Even though you may never have owned auction rate preferred securities, why should this be important to you?

The answer is, you may have owned them… but just never knew. If you had money invested in a closed end mutual fund — like a closed end bond fund, there’s a very good chance that a portion of your money was invested in these auction rate preferred securities. In fact, most leveraged closed end bond funds gain their leverage by issuing auction rate preferred securities.

But here is what makes this debacle even more curious: these investments are often highly rated (even AAA rated at times) and backed by 1 1/2 — or sometimes two times the investment. And they continue to pay interest.

So these investments actually ARE working — they’re just not working the way they were marketed.

And that’s where the problem lies… a failure to disclose. In many cases, these auction rate preferred securities were marketed to investors as cash equivalents. They were marketed as alternatives to CDs, money markets and other short-term parking places for cash. The brokerage firms will deny they were marketed as alternatives to short-term cash investments. The investors (sometimes called plaintiffs) will demand justice because they will claim they weren’t told of the risks involved, or the possibility for illiquid markets to emerge at any time.

In the never-ending game of musical chairs, when broker-dealers stopped actively participating in this market, the bids can dry up and disappear. What this means is you had “no way out” of these investments after 7, 14, or 28 days… you owned it.

This is the “disconnect” between investors and Wall Street firms. Over the years, so many “institutional type” products have filtered down to the retail level for individual investors. The problem is that they are not marketed properly. If individual investors knew everything that “could” go wrong with some of these exotic investments, they would probably not touch them with a 10 foot pole. After all, if clients want risk they can turn to the stock market. This was supposedly alternatives for short-term cash. So this can be a very painful message to hear… money you thought would be available every few weeks, is now tied up in a long-term investment.

The problem with liquidity and spotty disclosure was a lesson I learned nearly 25 years ago with oil and gas and real estate limited partnerships. The first question you need to ask when considering an investment is: “OK, sounds good. Now how do we get out of these things?”

If there’s no clear exit path, run. Keep it simple.

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