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Wednesday, April 09, 2008

Auction Rate Securities Compensation: Peanuts or Icing on the Cake for Brokers?

Dow Jones (no link available) touches today on an issue I’ve covered in my blog often: Wall Street’s compensation tied to the auction rate securities (ARS) market. Wall Street is claiming that “they picked these products because they offered higher yield for investors than other cash-like products, not because they generated fees for brokers.”

When compared to stocks and mutual funds, the compensation to brokers is marginal. However comparing ARS investments to mutual funds and stocks is flawed; a better comparison is to other so-called “cash equivalents” such as Treasury’s and money-market funds, which as Dow Jones states, “pay little to nothing.”

Whether the fees were as marginal as Wall Street claims remains debatable. One broker, Dow Jones reports, earned $5 for every $25,000’s worth of ARSs he sells plus a “trailer,” which is an annual fee of about 0.12 percent. That fee structure is consistent with our understanding.

But here’s the twist: we’re getting calls from corporations and high net worth individuals with $100 million invested in ARSs. Under this scenario, the broker would have earned a trailer/annual fee of $120,000 or more from this ARS client alone. If this client would have been placed in Treasuries, the fees would have been drastically lower. Peanuts? Or nice ten percent boost to a broker earning $1 million annually?

Admittedly it seems counterintuitive to me that a broker would risk his or her prized high-net worth and corporate clients by placing them in ARSs when they sought cash equivalents. Though I’d never underestimated Wall Street’s “need for fees,” it’s plausible that brokers were themselves duped by their own firms.

Here’s why:

A broker's Wall Street employer is paid for managing an ARS auction by the issuer - usually around one percent of the total securities auctioned. So, for example if a municipality issues $300 million worth of auction rate securities, the firm that manages the auction earns $3 million. Numerous auctions were being held daily so these fees racked up. Since the market is estimated to be $330 billion, conservatively Wall Street raked in over $3 billion in fees. An extra few hundred million - to borrow a quote from Jeffrey Skilling - is enough to “juice earnings” at least. And the manager overseeing a firm’s auctions' compensation is likely tied to the amount of fees generated too.

The auction fees could be a reason why ARSs were pitched so heavily to investors. Some brokers were at best naïve participants. But ignorance, while blissful, is not a justifiable argument. A broker has a fiduciary responsibility to inform a client of an investment’s risks. It doesn’t take an economist to realize that along with ARS’s higher returns there are greater risks, particularly liquidity. Clients should have been made aware that at any given time, Wall Street could pull out of the bidding process and freeze the market, instantly turning what was a highly liquid asset into a 30-year, low interest fixed rate bond.

I simply don’t buy into the argument that fees did not factor into the decision to put clients into ARS. Fees were small in comparison to other investments…ok…but clearly enough of an incentive to feed Wall Street’s greed machine.



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