There is no question that auction rate bonds are long-term bonds, and not cash equivalents. Their liquidity is dependent on their credit worthiness and a willing pool of buyers. Unfortunately, the credit worthiness of these bonds is directly tied to the monoline insurers and buyers are less willing to participate in the auctions.
It is also unfortunate that retail investors became holders of auction rate bonds. The Wall Street Journal's "Some Investors Forced to Hold 'Auction' Bonds" tells the stories of senior citizens that thought auction rate bonds are as liquid as cash. The WSJ cites a customer from Sun Trust Bank (NYSE:STI) that was shocked he could not sell his position at will. The implication being that retail customers did not know that they were purchasing long-term bonds with limited liquidity. Bonds that could only be traded in periodic auctions, and there might not be any buyers participating in the auction. Auction rate securities are not appropriate for unsophisticated retail investors.
Banks are now trying to soften the blow from their inappropriate investment sales. UBS (NYSE:UBS), Wachovia (NASDAQ:WB) and Citigroup (NYSE:C) are working on temporary liquidity solutions such as lines of credit and margin loans for their customers.
Just like in the subprime mortgage mess, the retail auction rate bond holders are not innocent either. I'm sure they knew that they were not buying a CD, treasury or money market fund; but they never imagined that the auction rate bond market would dry up. Retail investors can never depend on a broker's pitch to replace their own understanding of a product.
The Law Firm of David A. Weintraub, P.A is already soliciting clients from retail auction rate securities customers.
Disclosures: Author is long C and WB.