Wall Street is a product machine. They are always devising new “packages” to sell their customers. A basic word of advice I can never share enough with new and seasoned investors alike is: “Know what you are buying.” This hit me again last week.

Major brokerage firms settled class action suits with clients who bought a “risk-free” product called “auction rate securities.” Until February, auction rate securities had been a place investors could pocket a slightly higher yield without, they were told, “additional” risk.

Then, in the tumult of the credit crisis, the regular auctions failed.

This caused Goldman Sachs (NYSE:GS), Lehman Brothers (NYSE:LEH), Merrill Lynch (NYSE:MER) and the other investment banks to tell investors who owned these so-called “cash like” securities, “Whoop’s! The market for these securities is frozen… and so is your cash.”

Investors rushing to capture a slightly higher return inadvertently opened up the doors to risk exposure that they hadn’t expected. And the fallout from write-downs and lawsuits on auction rate securities has been severe. But that doesn’t mean this is the end of questionable financial products…

Are Auction Rate Securities As Safe As Money Markets?

The sales pitch for these auction rate securities had been that they were as safe as money market accounts, and almost as safe as cash. The bonds are, in reality, long-term securities, but the banks promised they would hold weekly or monthly auctions to set the interest rates and give investors the option of selling.

These auction rate securities are generally from:

• Tax-exempt institutions
• Municipalities
• Corporations
• Student loan providers
• And closed-end funds

Types of investments that would normally be associated with safety and security.

The financial firms liked lending at the low rates generally associated with short-term debt, while they were actually lending at longer terms. But because of the creative Wall Street facilitated auctions, this fact was obscured from investors.

And as long as investors were receiving their money, and the financial companies were receiving their fees, it looked like everyone came out a winner… until the auctions failed.

When they did, investors called their lawyers instead of their brokers… in the hope of getting some of their money back.

The largest of the Wall Street firms are buying back billions of dollars of these auction rate securities from affected investors. But this doesn’t solve the problem. Hundreds and thousands of other investors bought these same products from mid-size and online brokerage firms that haven’t agreed to settle.

It’s nothing new.

The Auction Rate Security Failure Exposes a Tainted History

If you are a student of Wall Street history, you know that auction rate securities have a soiled past.

“The Securities and Exchange Commission,” according to The New York Times, “reached a $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market. The SEC investigation centered on how bidding was conducted for these securities. Critics complain that investment banks have the upper hand in bidding because they can bid after seeing what other investors have bid.”

This lack of transparency is old news, yet it might as well be pulled from today’s headlines.

Auction rate securities are now history. The market hasn’t rebounded and investment banks are going to lose billions as regulators and courts force them to buy back these notes.

What’s most notable is that this debacle hit many people and institutions that shouldn’t have been victims. Small business owners and individuals who thought these notes like cash faced a liquidity crisis when they couldn’t get their money back.

And the institutions that used this market to borrow short-term funds saw the source dry up. Lack of access to this capital led to liquidity consequences. Everyone involved ended up getting hurt, and there were lessons learned on both sides of the lending borrowing spectrum.

Looking Out for the Next Questionable Financial Product

But that doesn’t mean this is the end of questionable financial products…

There are products out there right now that wouldn’t pass the sniff test, and many more on the way. And with the yield on many products trading in double digits, now is a good time to look around for new income investments. But when it comes to listening to your broker remember “caveat emptor” - let the buyer beware.

The next time your broker calls with a new product that you don’t fully understand, just say no. Warren Buffett is famous for avoiding companies whose product he cannot understand. Buffett was criticized for missing the tech boom of the 2000s, but he also missed the resulting crash. If a brilliant mind like Buffett is confused by these shell games, perhaps we should be, too.

With inventive minds working to package and repackage securities or debt instruments behind new wrappers, I guarantee there will be another exotic product coming out that seems too good to be true.

And it probably is. So stick with what you know.

Invest in understandable products from well-known agencies and companies. Many of these “new” products aren’t necessary to achieve above-average returns. There’s nothing wrong with stocks, bonds, ETFs and commodities. In fact, the only thing wrong with these investments may be the “Wall Street product machine” that tells you they aren’t good enough.

Perhaps they should be focusing more on finding investments that offer above-average returns, with below-average risk. It’s what we do here at The Oxford Club everyday.

Happy investing,

Floyd

Source: Auction Rate Securities: How to Avoid the Wall Street Product Machine