Learning Lessons from Auction Rate Securities

Back in February, James Stewart, an investor in

auction-rate preferred shares, complained that those shares were illiquid and that he was having difficulty accessing his money. He reckoned that if he couldn’t get his money out of the closed-end fund he invested in, then his broker ought to give it to him instead.

Well, it’s taken a while, but Stewart has got what he wanted. Not that he’s happy about it:

I’m glad that I and thousands of other unwitting investors appear likely to get back our money, albeit not for months. But that’s not going to restore the trust that’s been destroyed. We need to know the truth. We need to know who is taking responsibility. We need to know there has been accountability. And we need to know how we can be sure it won’t happen again.

Why do "we need to know" all these things? In order "to restore the trust that’s been destroyed"? Well maybe that trust should never have been there in the first place, and the best way to ensure that this won’t happen again is for investors to grow up and start taking responsibility for their actions, rather than seeking to build their assets on a bedrock of trust in stockbrokers.

Stockbrokers are a means to an end: they can help you buy and sell financial assets, and sometimes give you useful information, as well. Stewart says he wound up in these products because he "got a call urging me to take advantage of an offer that was being extended to valuable clients". He wasn’t asking for anything: he was being sold a product.

How many other times has Stewart happily bought whatever his broker was selling? I suspect that if he did so and the securities in question went up, he patted himself on the back and told himself that he was a most astute investor. And then, the one time he does so and the investment turns sour, he immediately turns on the brokerage and blames them for everything.

If Stewart is looking for people to take responsibility, there’s a key player in this whole affair staring out at him from the mirror. Stewart is a sophisticated and knowledgeable investor; if he wants to be sure that this won’t happen again, then he’s entirely capable of researching potential investments before buying them, rather than simply taking the word of a stockbroker working on commission.

I’ve said before that an excess of risk aversion was largely responsible for the present crisis in general, and for the crisis in auction-rate securities in particular. Stewart could have decided to take a reasonable amount of risk in the markets, done his own homework, and bought assets accordingly. He could have decided that he wanted risk, not done any homework, and bought whatever his broker was selling. That course of action carries the extra risk associated with conflicts of interest at the stockbroker, but at least he’d be willingly and deliberately taking that risk. He could have decided that he didn’t want any risk, done his own homework, and bought assets accordingly. That, too, would have made sense. But instead he plumped for the one option which really doesn’t work at all: he decided that he didn’t want any risk, didn’t want to do any homework either, and bought whatever his broker was selling. An investor of Stewart’s sophistication should never end up in that particular corner of the grid, and I do hope that his desire to "restore trust" doesn’t mean that he wants to go back there again.