Lesson for Millionaires: Taxes Are Certain; Derivatives Aren't

The Maher brothers realized their shipping business needed more capital, Also they faced a massive estate-tax hit if either brother died, today's Wall Street Journal reports (subscription). So they sold out for more than $1 billion and gave the money to three banks to invest in "conservative, cashlike investments."

Unfortunately, one of the banks chose to invest heavily in "auction-rate" securities instead of Treasuries or money-market funds. Now the brothers hold auction-rate securities, purchased for $286 million, they cannot sell at any price.

Many rich investors like the Mahers are now discovering they hold exotic securities wrongly thought to be safe. As a result, the subprime-mortgage crisis that began with America's most financially strapped borrowers is climbing to the top of the wealth ladder, reaching into the pockets of America's millionaires.

Yikes! Just noticed that this story on the problems of auction-rate securities is one of four in today's Journal.

Another tells us what auction-rate securities are:

These securities are issued by municipalities, student-loan authorities, museums and many others, with interest rates that reset through bank-managed auctions every week to 35 days. The auction-rate securities are essentially long-term debt, but investors treat them like a liquid, short-term holding because of the auctions. The problem is that investors have balked at the auctions lately, sending interest rates on these securities on a wild ride.

This article reports that the New York area Port Authority just saw the annualized rate it must pay on its auction-rate securities jump from about 4% to 20%!

Yet another article spotlights student loans:

The subprime-mortgage crisis has driven investors away from the asset-backed securities that are a crucial source of capital for many student lenders, prompting smaller concerns like College Loan Corp. and Nelnet Inc. to stop making certain kinds of loans. And in recent days, the market for auction-rate securities, a type of financing vehicle tied to student loans, has seized up.

Finally, Ahead of the Tape suggests that if we enjoyed last year's meltdown of mortgage derivitives, we'll love 2008's shunning of auction-rate securities:

Some guy can't pay his mortgage, and the next thing you know Citigroup needs to raise cash. Who knew?

Now, problems are bubbling in two other backwaters of the credit markets, auction-rate securities and tender-option bonds. Like SIVs and conduits, these financing vehicles issue supposedly safe short-term securities that are meant to appeal to the most conservative investors. But the credit-risk panic has shaken faith in those assets, as well, and suddenly your daughter can't get a student loan in Michigan. Once again, who knew?

Sounds like it's time to declare a

Yellow Alert for high-net-worth investors

All millionaires should be vigilant, take notice of their investment holdings, and report suspicious derivatives to their wealth managers immediately!