Trapped in the frozen ARS market

MARCH 2006

Take it, Phil. It’s free money,” my broker said. Free money? This is a joke, right? Is this some kind of broker humor? Where’s the rimshot? He’s never shown much of a penchant for levity. So I asked with complete sincerity, “Are you kidding?”

“Not a joke,” my broker replied, sounding as if my skepticism is tweaking his sensitive soul. “I’m trying to get you into auction-rate securities. A really good deal,” he said in a confidential tone, as if he were handing me a key to a secret treasure. He went on to explain that auction-rate securities are “cash equivalents. Completely liquid. Safe as U.S. Treasury bonds — and with a higher yield.”

Cash equivalent? What, exactly, did he mean?

“Like I said, it’s just like a money market. You’ve been trading stocks forever. Don’t you get it?”

I’m skeptical. The tricky little catchphrase, “cash equivalent” — it has an odd, not-quite-tangible ring to it. As far as I’m concerned, there’s cash, the green “In God We Trust” paper you stuff in your wallet, and no real equivalent.

Still skeptical, I ask for a prospectus. This elicits a gruff little chuckle from my broker. His laugh has the indulgent tone of a parent whose toddler asks why the sky is blue.

“Trust me,” the broker sighed. He’s impatient with my questions.

I hear his cell phone chirping in the background. Seems it is always chirping. The caller must be a VIP, someone with access to my broker’s private line.

“Hey, look, I really think I need a prospectus,” I persisted. “Do you have one or don’t you?”

Now he is annoyed, a bit huffy.

“Yeah, well, I think we do. I’ll ask around. It’s the size of the Manhattan telephone directory. You up for that kind of reading?”

Long pause. The cell phone is louder now, prodding, as if the gadget is reminding me that its owner has urgent matters to deal with and that my infantile skepticism, my wanting a prospectus, is getting in the way of him making really big bucks.

“Trust me,” the broker repeated, only now he’s obviously put out. I half expect him to hit me with something like, “Where’s the love, man?”

“How long have I known you?” he asked. “Have I ever steered you wrong?”

No, not really, and that’s because I seldom expect him to rise up like a golden Master of the Universe — a “MOTU,” the Polynesian word for a coral atoll or lagoon, typically shark-infested.

I have been trading stocks and bonds for decades, in good markets and bad. And throughout this tedious slog through the market, I have known only one MOTU. Not the one I’m talking to today. He’s merely a hustling salesman, a plain-vanilla financial adviser, an ordinarily well-meaning schlemiel who calls with occasional news of the latest initial public offerings being pushed by his company, A.G. Edwards & Sons Inc.

He often puts a sexy spin on those quirky IPOs, for which I pay no fee, though my broker picks up a little undisclosed incentive on the side if he closes the deal. As with his talk of auction-rate securities, he speaks of IPOs in hushed, confidential tones, as if I’ve been chosen by the gods and am lucky to get my hands on one of those derivative-laden pieces of junk, the vast accumulation of which, on an international scale, eventually delivered us to the “Global Credit Crisis of 2009” and the biggest loss of investor wealth since the Great Depression.

But about those auction-rate securities …

“I’m not going to twist your arm,” the broker said at last, tiring of my questions. His tone turned slightly hurt, as if he were my dear friend and I was the ingrate.

“I can get you a full basis point over anything in money market. Auction-rate securities are completely safe. Completely liquid. Just another form of cash. So — you in or out?”

The cell phone is no longer chirping.

“OK. Do it.” It is an act of trust that would come back to haunt me in ways I never could have imagined.

9 A.M., VALENTINE’S DAY, 2008

I was seated at my computer, prepared to face a day steering my little stock-and-bond portfolio through yet another storm of manipulated market short selling on Wall Street. Can’t say I was looking forward to it. By now, I was sweating marathon days and nights. Deep into microanalysis, I was starting to feel like the obsessive gamblers in the pages of “Fools Die,” Mario Puzo’s classic novel of life inside a Las Vegas casino. But I was no gambler. Safety was my byword. This was not a time to take big risks.

After almost eight perilous years of the Bush administration’s passion for deregulation, I had grown used to the “market guy’s” lack of economic smarts and Wall Street’s cocktail of greed and corruption. Short-sellers were driving the markets into the pits, and the regulatory cops were asleep. The Securities and Exchange Commission had long ago faded into the zombie zone. Insatiable Wall Street greed and anarchy had begun to erode the broader stock and bond markets, and they were now seeping into the internals of the larger economy.

I tried not to think too much in macro terms. But caught in a 24/7 news cycle, and as a lifelong newsman, I was addicted to a jumbo diet of daily reading. I voraciously consumed business news and opinion from multiple newspapers and magazines, dozens of Internet news sites and financial wire services, videos and TV shows. I began to think I was losing it when Jim Cramer of CNBC began to show up in my dreams.

It was clear that an economic storm was brewing. It was more felt than actually seen in the daily rush of numbers and news stories. I was haunted by an unrelenting sense of an enigmatic presence, shadowy and malign, just waiting to take me and my little portfolio to the woodshed.

The bears, who eat small retail investors for breakfast, rallied the short-sellers and hedge fund weasels to bet against every company in sight, especially the banks, and in the process were sucking real value out of the economy. No one dared say it, but the market swamis were busy killing capitalism.

Yes, the bears were growling, snarling, gnashing their teeth. Abusive trading behavior was being fueled, even quietly applauded, at the highest levels of government. President George W. Bush, the cowboy market guy, assured us “the fundamentals of our economy are sound,” even as the SEC shrugged off Bernie Madoff whistle-blowers and the disturbing fact that the “too big to fail” investment banks, the so-called I-banks, had leveraged their bets to unprecedented levels.

The market action was so furious, so often bewildering, that I had begun to feel like a tightrope walker without a net, clutching a copy of the Old Testament in hopes of a higher intervention.

Who wants to think calamity while being warmed in the memory of a once-roaring bull market that lasted from 2002 to 2007? Fixating on the worst might have been the prudent thing to do, up to a point. But the hard-core rigor of negative thinking is often unsettling, likely to confuse the detail-oriented small investor like myself, who wallowed in voluminous research, snapped up stocks on the dips and sold them on the highs, and whose luck brought home steady double-digit gains. Plus, nearly a third of all my stock profits were sitting in those supersafe cash equivalents — those auction-rate securities. I was OK. Safe. That’s what I kept telling myself.

In retrospect, the smartest move would have been to cash out. Sell everything. Sock away the gains in safe municipal bonds. Get back to writing full time, my real profession. Let the market addiction burn itself out. Stick to basics. I was thinking retirement — a retirement I had earned over many years of ups and downs.

[More: Addiction to Day Trading: It’s compulsive say gambling counselors]

I was pondering these options when the phone rang. I could not have known that the calm, paternal voice on the other end of the line was about to turn my life into a living hell.

“We’ve got a problem.” It was my new broker at Wachovia Securities, which had purchased the A.G. Edwards brand. Jim was the savvy guy who had replaced my initial broker, the ARS hustler. His voice was tranquil, devoid of emotion, and I pictured his bulky frame hunched over his Bloomberg terminal. I imagined he was calling with news of something simple — a computer glitch that had refused to confirm one of my orders. Unlike my first broker, I trusted Jim completely and respected his experience.

“What kind of problem?” I asked.

“It’s the auction-rate-securities market. It’s, uh, well — the auctions are failing. “

“Failing?”

“Yeah, well …”

“What?”

“Market’s frozen,” Jim informed me. “For now, anyway.”

“Frozen! What are you talking about?”

He sucked in his breath and explained the action — or lack of it.

“Not enough bidders out there,” he said. “We’re getting a lot of auction failures. But the yields are sky-high.” He explained gleefully that the Port of New York was paying double-digit interest, tax-free, to attract new bidders. “Not too shabby,” Jim said. “Relax and enjoy it while it lasts.”

I pressed for more information.

He explained that liquidity dries up when auctions fail because there aren’t enough bidders to make the auctions work properly. Before each auction, ARS investors may sell their holdings, hang on at a specified interest rate or hold at whatever new rate or dividend is set by the auction. The size of any given auction depends on how many current investors want to sell or hold their so-called cash equivalents at a certain interest rate. What my broker was describing as a liquidity problem had sent bidders heading for the hills, leaving $336 billion in ARS and auction-rate preferred securities in a deep freeze, with an estimated 146,500 investors holding the bag.

“How long is this … this freeze going to last?” I wanted to know.

Some bonds were paying high penalty interest rates, but what kind of idiot enjoys being informed that he can’t get his cash out?

“No telling. Like I said, it’s a liquidity thing.” The answer was given with a kind of cosmic shrug, an offhand way of saying he had no idea what to expect. When brokers have no answers to pressing questions, you can expect big-time trouble.

The first onset of dizziness hit me like a shot of whiskey. A knot was forming in my gut. I tried to speak but was made temporarily mute by a growing awareness that I was in serious trouble, the kind of awareness that insists on being recognized even when you want it to go away. In those first confusing moments, I felt like a boxer in the ring with an opponent in a fixed fight. The banks were the ringside judges; they held the score cards, and each one of them had been bribed to score the fight in my opponent’s favor.

I had next to no facts on the numbers of bidders at these auctions. I knew the interest and dividends paid out by these suddenly toxic “better than money market” bonds were spiking. This wasn’t supposed to happen. How long could this last? As it turned out, my first broker neglected to tell me that many of the ARS bonds were actually long-term debt obligations with maturities of 20, 30 and even 40 years.

My ARS, the majority of them, were tied up in 30-year student loan authority bonds — easy to buy but the hardest bonds to sell when the going gets tough. Had I known these bonds carried such long maturities I never would have purchased them.

* * * * *

In retrospect, I suppose I should have been better-prepared for the shock. Years earlier, when I first began what amounted to amateur day trading through a Merrill Lynch & Co. Inc. branch in Sarasota, Fla., I had come face to face with a whole new set of emotions.

I’d go from days of virginal profit-rich euphoria to “Texas Chain Saw Massacre”-style fear and loathing. When the bear was busy tearing the limbs off of small investors like me, I’d bolt awake in the middle of the night soaked in sweat brought on by nightmares in which the world’s stock exchanges had crumbled and the U.S. government had defaulted on its bonds. Ruin — it’s the darkness at the heart of every serious investor. These are the horrors of the novice.

The ARS shock had the power to fling me back to thoughts of ruin, shame, destruction of hope. We live in hope and die in despair, and illiquid money is nothing but despair. I heard the whirring chain, and unlike my early trading days and sweaty nights, this time it was for real. It is one thing to lose money betting on a stock; it is quite another to be robbed of it, to be fleeced by a Wall Street banking cabal that was beginning to tear itself apart after years of insane risk taking and malfeasance.

“Look, it’s a temporary thing,” my broker, Jim, said later. “Nothing’s forever.”

He was trying to be a good guy. But between the lines, it was clear that he had no firm grasp of the situation. For a moment, I actually felt sorry for him. “You get it, right? The markets are hung up. We’ll fix it,” he said with a kind of clerical unctuousness. He promised to do his best to get my money back. He’d make sure Wachovia’s bond desk took care of me. By now, however, his assurances were meaningless. I wanted my cash, and I wanted it now.

Before I could fling a pent-up volley of epithets at him, I was muffled from within by a sense of encroaching darkness. I don’t know how else to describe it. It was a fear-driven blindness of the psyche. And fury. Plenty of fury. Though I didn’t realize it at the time, fury — guided and multiplied — would become my best ally.

Phil Trupp is a veteran journalist and author of several books. This article was excerpted from his book, “Ruthless: How Enraged Investors Reclaimed Their Investments and Beat Wall Street” (John Wiley & Sons, 2010).

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