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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST Wednesday, February 27, 2008: Auction Rate Preferred Auction Failures (Cont'd). I start with these words because this column needs to appear on more search engines.

To sum the story up: There are $60 billion of auction rate preferred securities around. These securities were sold by brokers as cash or cash equivalents -- safe places to tuck your short-term money away for a week or a month. More importantly, they were also sold by the issuers -- Nuveen, Eaton Vance, BlackRock, Pimco, Gabelli, Van Kampen, etc. -- as cash or cash equivalents.

When you needed your money, you simply put your securities up for auction and bingo you received 100% of your money back. The only auction part of this system was the interest rate you would receive for another 7 or 28 days. It varied, depending on what short-term rates were doing at that time. The system worked because a number of auction makers, like Citibank, Goldman, Morgans, Wachovia, Merrill Lynch, Lehman Brothers, UBS Paine Webber and Bank of America, etc. always bought the securities no one else wanted. They paid for them with their own money, took them onto their balance sheet and tried to sell them at the following auction, often successfully.

The system worked fairly well for 20+years. But then two weeks ago, Citibank decided it no longer wanted to buy the ARS paper that didn't sell. The reason? It probably came to the conclusion that it simply didn't have enough capital -- what with the mess that sub-prime and other dumb bad investments had done to its capital. That caused everyone else say to themselves, "We are not legally obligated to support this market. Let's pull out." Once the banks had pulled out, the auctions started failing... and of course, at that point nobody wanted to buy these securities since it was evident that they were unsellable. If you bought them you were stuck with them.

And that's where we stand today. Thousands of investors -- individuals and corporations -- holding $60 billion of securities they can't sell. This is a massive disaster, with huge legal implications. Fact is all these investors were sold these securities as cash or cash equivalents by brokers, such as Deutsche Bank, Wachovia, Citibank Smith Barney, Merill Lynch, UBS, and hundreds of small brokerage firms all over the country. Fact is these investors were basically sold a dud investment. These securities at present have no market, hence no value. For investors who have their April 15 tax payments (or other upcoming payments, like a new house or a new business) sitting in these things, this represents a huge financial disaster.

Several brokerage companies have, however, offered to loan these investors money against these securities. I have been offered a loan against my securities. And the rates I'm hearing on these loans are, in some cases, actually less than what these securities are currently paying. My securities are now slightly over 4.2% triple tax-free. The problem with this "deal" is that you never know what rate your ARS will re-set to. It may be less than what you have to pay your lender. And so far, I haven't seen the terms of these loans.

Fast forward to last night. Nuveen, one of the largest issues of auction rate preferreds, held a conference call "to discuss topics related to Nuveen closed-end fund preferred shares." You can listen to a replay. Call 1-888-266-2081 and enter conference access code 1207768. The call replay will be available through March 4, 2008.

I believe this was the first conference call devoted to auction rate preferreds. Over 2,000 people were on it -- the largest by far I've ever been on.

You won't learn much from listening to the conference call. Nuveen management has no solution, no timeframe and basically zero sympathy for the fools (me included) who bought its auction rate preferred securities.

There are many solutions to giving fools like me the ability to sell or redeem our shares. The easiest is called de-leveraging It means selling bonds in the fund and buying our securities back with the proceeds. Another way is to change the fund from a closed-end fund to an open-ended fund -- like a mutual fund. This was allow us to cash our securities in at the end of a day, as we do with mutual funds.

There are impediments to this -- the major one being the greed and arrogance of Nuveen management. Nuveen management gets paid a management fee on the total assets (i.e. all the bonds) holds. If it sold some to pay you and me off, it would earn less money. One caller actually asked if Nuveen management had considered foregoing management fees until this disaster is resolved. And the answer was a resounding, "NO." It was the only question that actually got a definitive answer. Everything else was met by a resounding, "We understand your pain. We're working on a solution. We have no idea what that solution might be -- if there ever is a solution. And we don't know when that (undefined) solution might happen."

The call gave arrogance a whole new meaning. My favorite part of it was the fact that Nuveen scheduled only one hour for the call. They took a few questions from brokers -- none from private investors (and none from me), said "thank you and good night."

My money management friends who are much smarter than I am, explained to me, "Harry, Nuveen management has a major incentive to do absolutely nothing. They have your money. It's cheap money. They have your cheap money forever. And they're going to keep it."

In the old days when I ran a company and a customer complained, the first thing I would do would be to solve the customer's problem. If it meant taking money out of my own pocket, I'd do that. Customers are king. Customers are all I had. I wouldn't wait two weeks. I wouldn't hold a conference call and say nothing. But Nuveen management obviously doesn't feel that.

The only solution to this is noise. We need to make lots of it. We need to bring major pressure on the brokers who sold us this garbage and they, in turn, need to put pressure on Nuveen management to solve this. I'm collecting names of owners of these securities. Send me an email. We need to talk. This requires many brains. Send me an email. I treat everything confidentially. Remember I have $4.5 million of Nuveen securities. I have a major incentive to put pressure to solve this. And Nuveen actually does have a major incentive to solve this -- if they don't, nobody will ever deal with Nuveen ever again. But getting their management to understand this seems a major task. As of last night's call, they still hadn't gotten it.

Remember all my articles about "Mattress Cash?" Please read this. It's from today's Wall Street Journal, page D4.

Risks of a 'Safe' Investment Are Found Out the Hard Way
February 27, 2008; Page D4

They were sold as a liquid, safe, slightly higher-yielding, tax-exempt alternative to money-market funds. I should know, since I bought some. For several years I've been parking a good part of my cash in auction-rate preferred shares.

These are typically shares of a closed-end fund that used the proceeds to buy triple-A-rated securities. (In my case, municipal bonds.) There was virtually no interest-rate risk since the rate was set at frequent auctions of the shares. My shares were issued by BlackRock, the asset-management firm almost half-owned by Merrill Lynch; many other firms also sold the securities. When I needed cash, I simply redeemed shares, as I did last month when I took advantage of the market downturn to buy stocks.

Last week, when I read that some tax-exempt entities, even the Metropolitan Museum of Art, were suddenly paying exorbitant rates because of "failed" auctions for municipal bonds, I didn't suspect this would have any immediate impact on me. I heard nothing from Merrill Lynch, which sold me the ARPS. My account statement continues to show the shares at full face value.

I became more concerned as news reports of failed auctions continued last week. Finally, I called a broker to ask about the status of my ARPS. I learned that recent auctions of these preferred shares have indeed failed, which means there were no buyers at rates acceptable to the sellers. The market has virtually collapsed. There is no guarantee the shares can be sold. Indeed, it's highly unlikely they can be. What was a ready source of cash is now essentially frozen.

Last year, when some money-market funds turned out to hold some mortgage-backed securities and faced a liquidity crisis, their sponsors stepped in and redeemed the shares at face value. This seemed the only decent course, not to mention a good investment in customer loyalty.

But when I asked a broker at Merrill Lynch if it would do the same for owners of these money-market equivalents, the answer was "no" -- not after the multibillion-dollar write-offs Merrill has taken on illiquid assets. Merrill Lynch and the other big banks that sold these shares have stopped making a market in them, which is a major reason the auctions have failed.

Merrill Lynch, when asked for comment, told me: "We are offering our clients loans which can give them liquidity." It wasn't yet clear whether these would be interest-free loans, which they certainly should be, in my opinion.

BlackRock commented on its Web site that "We do not see any issues with the financial health or fundamentals of these funds as a result of the failed auctions." The firm also said it "continues to closely monitor developments in the ARPS market."

The amount of auction-rate preferred shares outstanding is massive -- an estimated $330 billion. Many firms besides Merrill Lynch sold the shares. Fortunately, I have no immediate need for the cash. But given that these securities were marketed as money-market alternatives, I'm sure that there are plenty of people who do, and will be in for a rude shock when they try to redeem them.

I hope that this will be a temporary paralysis and the market will come to its senses. These securities still carry a triple-A rating. None of the underlying bonds have defaulted. Interest is still being paid, at a slightly higher rate than before.

In my view, any failure of the big banks to honor what is at least a moral commitment to the people to whom they sold these shares is appalling. At least two states are investigating, and I would expect them to be joined by the Securities and Exchange Commission.

So is any fixed-income security short of U.S. Treasurys and the biggest, most liquid money-market funds safe at this point? I'd like to think so, but if you own any securities that depend on investor confidence or raise any liquidity issues, be aware of the risks.

As I've mentioned before, creeping contagion in capital markets are seriously hurting the economy (and in turn, I believe the stockmarket, whose prospects I continue to not like), read this piece from Bloombergs:

Bernanke's 'Brilliant' Fed Vision Evokes Investors' Frustration

By Craig Torres

Feb. 27 (Bloomberg) -- In the second week of August, the short-term fixed-income sales team at JPMorgan Securities Inc. sat stunned as the trillion-dollar market for asset-backed commercial paper began to collapse.

In normal markets, JPMorgan sells $25 billion of short-term IOUs for clients daily. "Within the span of six or seven business days, every single investor stopped buying asset-backed commercial paper tied to structured investment vehicles,'' said John Kodweis, a managing director at the New York bank.

How the Federal Reserve has responded to that credit debacle -- the worst since the savings and loan crisis of the early 1990s -- defines Chairman Ben S. Bernanke's reshaping of the world's most important central bank.

With its focus on building consensus around long-term goals and attempts to separate liquidity from broader monetary policy, Bernanke's approach evokes appreciation among some economists. He's also caused frustration among traders trying to discern his intentions.

"The chairman walked into a job that I can best describe as trial by fire,'' said Allen Sinai, president of New York- based Decision Economics Inc. Separating interest-rate policy from liquidity tools was "absolutely brilliant,'' he said.

To critics, his failure to quickly recognize the economic impact of the market tumult exacerbated the slowdown and meant that when the Fed began cutting rates, reductions needed to be deeper and faster.

"It's hard to be democratic in a crisis when leadership and image are so key,'' said Karl Haeling, head of strategic debt distribution in New York at Landesbank Baden-Wuerttemberg, Germany's fourth-largest bank. "The Fed seemed awfully smug until August that this subprime issue was not a big issue. Then, they had to come out with both barrels blasting.''

The 54-year-old Fed chairman will give his semi-annual testimony to the House Financial Services Committee today. His remarks will likely deal with risks to growth, while underscoring that inflation remains a threat.

In August, Bernanke defied traders' predictions of an immediate cut in the federal funds rate, which affects borrowing costs for consumers and businesses. Instead, as credit dried up, he responded with a $35 billion cash injection into banks Aug. 10. Seven days later, he lowered the cost for banks to borrow directly from the Fed.

Officials waited a month before lowering the federal funds rate. Even then, they said "inflation risks remain,'' leading some on Wall Street to complain Bernanke was out of touch.

"They stepped on their message in the first five months,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs. "They weren't willing to emphasize why, or how they arrived at that inflation risk.''

Meanwhile, the economy continued to weaken.

As mortgage delinquencies rose to a 20-year high in the third quarter, Fed officials cut the federal funds rate just a quarter-point in October and said they thought inflation risks "roughly balance'' risks to growth. Coming after a half-point cut the previous month, the October action was seen by economists including Stephen Stanley as a signal that policy makers thought they had eased credit enough to sustain the economic expansion.

"It really kind of scares me that the Fed had no idea things were going to get worse,'' said Stanley, chief economist at RBS Greenwich Capital Markets Inc., and a former member of the Richmond Fed staff. "They were totally blindsided by the deterioration in liquidity conditions after the October meeting.''

By December, investors were expecting some promise of year-end liquidity following the Federal Open Market Committee's meeting on Dec. 11. They didn't get one. Instead, policy makers again cut the benchmark rate a quarter point and maintained their view that "some inflation risks remain.''

Investors showed their disappointment, driving the Dow Jones Industrial Average down 2.1 percent. Markets were setting up for a panic.

The Fed again surprised Wall Street the following morning, announcing that the central bank would loan as much as $40 billion for 28 days through a facility that would let banks borrow directly from the Fed.

The Fed also arranged swap lines with the European Central Bank and the Swiss National Bank, allowing them to channel dollars into their markets.

The Fed's response to the credit squeeze "wasn't handled with the aplomb you would have liked,'' said E. Craig Coats Jr., co-head of fixed income at Keefe Bruyette & Woods Inc. in New York. Still, "it was actually pretty creative, and I give them credit for trying.''

Only after Fed officials saw the potential for higher unemployment and indicators such as retail sales declining did they have confidence that inflation risks were subsiding. They then cut the benchmark rate 1.25 percentage points in nine days in January, the fastest reduction in two decades.

Bernanke's goal of keeping policy trained on a medium-term forecast while flooding the banking system with short-term cash shows how the chairman has adopted some of the discipline of inflation-targeting central banks in the United Kingdom and Sweden.

"Good central banking is not a matter of magic touch,'' said Doug Elmendorf, a senior fellow at the Brookings Institution in Washington, and a former Fed staff economist under both Bernanke and former chairman Alan Greenspan. "It is a matter of doing something systematically right.''

The Bernanke system also includes changes in governance and communication. Bernanke persuaded fellow members of the Federal Open Market Committee to publish their projections four times a year instead of two, and stretch out to a third year. The exercise transformed the undefined preferences of Greenspan into numeric priorities of an institution.

Bernanke votes last in policy meetings, unlike Greenspan who argued his policy choice first. Bernanke calls it "depersonalization.''"

It is commendable that they are implementing these changes in the midst of the most challenging environment for central banks in decades,'' said Angel Ubide, director of global economics in Washington at Tudor Investment Corp., a hedge fund.

Bernanke's scholarly work on the Great Depression also came into play as he retooled the Fed's function as lender of last resort to grapple with what NYU economist Nouriel Roubini calls "the first crisis of financial globalization and securitization.''

Instead of bank depositors fleeing banks, as in the Depression, it was commercial paper investors who wanted safety. These investors were running from off-balance-sheet structured investment vehicles, which have some features of banks with none of the backstops.

Kodweis recalled how the normal din of ringing phones fell quiet inside JPMorgan's mid-town Manhattan trading room as credit markets dried up in early August. "It was frightening at times,'' he said. "It took longer to sell commercial paper, it was later in the day when we were done, and maturities were increasingly shorter.''

The rush by money market funds to securities not tied to mortgages or consumers created new problems for the Fed.

On Aug. 20, the three-month Treasury bill yield declined 0.66 percentage point in one day to 3.09 percent, the biggest fall in two decades, in a stampede to safety.

On Aug. 21, Bernanke, who had been holding twice-daily conference calls with the New York Fed, reached for another tool. The New York bank halved the fee for dealers borrowing securities from the central bank's portfolio.

By November, Fed officials faced a new challenge. "Banks wouldn't lend to each other,'' said Haeling. "There was enough liquidity in the system. The trouble was it wasn't getting to the right places.''

The price of three-month interbank dollar loans in London rose to an average 60 basis points over the federal funds rate in November, from 10 basis points in January to July.

By mid-February, the Fed had auctioned $130 billion in term reserves. The Libor to federal funds rate spread fell back.

Now, Fed officials have said they are considering making the facility permanent.

"He did creative intelligent things about the banking problem. He recognized that a central bank has two concerns -- the financial problem and the macroeconomic problem,'' said Allan Meltzer, a Fed historian and Carnegie Mellon University economist. "He acted appropriately.''

Why do I think this is funny?
Ralph returns from the doctor and tells his wife that the doctor has told him he has only 24 hours to live.

Given this prognosis, Ralph asks his wife for sex. Naturally, she agrees, and they make love.

About six hours later, the husband goes to his wife and says, "Honey, you know I now have only 18 hours to live. Could we please do it one more time?" Of course, the wife agrees and they do it again.

Later, as the man gets into bed, he looks at his watch and realizes he now has only 8 hours left. He touches his wife's shoulder and asks, "Honey, please... just one more time before I die ?" she says, "Of course, dear." And they make love for the third time.

After this session, the wife rolls over & falls asleep. Ralph, however, worried about his impending death, tosses & turns until he's down to 4 more hours. He taps his wife, who rouses. "Honey, I have only 4 more hours. Do you think we could...?"

At this point the wife rolls over and says, "Listen Ralph, I have to get up in the morning... you don't.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

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