I’m not sure what happened to the legendary “prudent man,” but if he isn’t dead he must be lying in a coma somewhere. At least that would seem to be the case, from all the losers pointing their fingers at others for getting them into various financial debacles.
Everyone claims victimhood. No one got greedy or took heedless risks.
In the past, the “prudent man rule” argued that sensible people were careful with their money. An 1830 ruling by Massachusetts judge Samuel Putnam spelled out the principle in a case about the legal duties of trustees. The judge noted that, “men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”
Prudence and discretion seem pretty rare in recent years. Many people apparently forgot about “probable safety” in their haste to earn slightly higher interest on investments or to pay slightly less interest on money borrowed.
Nowhere is this phenomenon more evident than in the market for “auction rate securities.” These are debt securities that are issued by corporations, municipalities and nonprofits such as hospitals or even HMOs. The interest rate for these securities is determined at auctions held by financial firms at short intervals, usually every one, four or five weeks.
The intent is that these frequent auctions be highly liquid, with many buyers, many sellers and open competition.
However, people of “prudence, discretion and intelligence” know that things don’t always work the way they are supposed to. In case of an auction where no one offers their security for sale, (an “all-hold” auction) the interest rate drops to a contractual minimum specified in the bond that is usually well below what the market rate had been.
In this case, investors holding the bonds will earn less money than anticipated. Their investment will be less profitable.
In a case where there are few or no buyers (a “failed auction”), the interest rate ratchets up to a contractual maximum, often well above what the market rate would have been under normal conditions.
With a failed auction, bond issuers end up paying higher interest than planned. The increase can be considerable, causing severe cash flow problems for these borrowers.
The financial institutions that deal in these securities have an interest in things running smoothly. So they may choose to “make a market,” buying some securities for themselves when there are too few buyers and selling some when there are too few sellers. But they have no legal obligation to do so.
Since early February, many such auctions have failed. The New York Port Authority had been paying 4.2 percent interest on its securities, but that soared to the penalty rate of 20 percent when no one wanted to buy. Even in auctions that did not fail, interest rates jumped. For example, Park-Nicollet Health Care Services saw interest on some of its securities rise from 3 percent to 13 percent.
Investors who bought these securities find they cannot sell them if they need money for other purposes. Yes, they are earning good interest, but their money is tied up indefinitely.
Everyone is shocked, simply shocked, that things did not evolve as they had hoped. And, of course, they all were led down the primrose path by the financial institutions that helped borrowers issue their securities or helped investors buy theirs. None of them happened to see the small print specifying what would happen if someone held an auction and no one came.
Of course, lawyers already are flocking to the scene to bind up the wounds of all innocent victims.
The financial institutions involved may be found liable for misrepresentation. And there is some comic relief in hearing chief financial officers with MBAs earning six-figure salaries whining that they had absolutely no idea interest rates could jump suddenly.
But our economy is not going to be healthy until we return to a situation where both borrowers and lenders “manage their own affairs … considering the probable income, as well as the probable safety of the capital to be invested.”
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.