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Tuesday, March 11, 2008

Auction Rate Securities Taken Up By Congress

Tomorrow Barney Frank (D-MA), Chairman of the House Financial Services Committee, will hold hearings into the municipal bond market. After reading the press release, it appears most of the hearing will be dedicated to the “impact on state and local governments and other municipal bond issuers as the current credit crisis worsens.” It is my hope however that a significant portion of the hearing will be dedicated to questions pertaining to the financial services industry’s auction rate securities (ARS)-related conflicts of interest and the manner in which these instruments were peddled to investors.

On the third panel will be Martin Vogtsberger, Managing Director and Head of Institutional Brokerage, Fifth Third Securities, Inc. on behalf of the Regional Bond Dealers Association. Given the allegations against the industry, he is certainly in a hot seat.

One of the specific issues that Congress should raise is whether the industry is living up to its own “best practices” put out by the Securities Industry and Financial Markets Association, including Wall Street’s self-obligated promise to educate “investors as the material features” of auction rate securities including disclosure regarding auction procedures, conflicts of interest, liquidity and other risks. It seems clear the industry fell down and did not meet this minimum standard.

To wit, after Wall Street was caught rigging the ARS market the SEC conducted industry-wide enforcement action imposing fines upon the violators. And clearly this didn’t stop Wall Street from taking advantage of its conflicted position. For example Wall Street failed to disclose when they were making bids on ARSs, which would have provided investors an indication of the ARS market’s true liquidity and risk. Likely Wall Street propped up the market so that firms could continue to charge underwriting and auction fees to ARS issuers, which includes local government and municipalities. It was apparently typical for banks to charge a one percent underwriting fee to issuers then hit them up for a .25 percent fee to manage the auctions.

Furthermore, Wall Street pitched these instruments as “cash-equivalents,” a position not even corporate CFO’s can take, but as the New York Times aptly points out in Sunday’s business section, ARSs are far from cash.

The combination of Wall Street’s insatiable appetite for ARS fees coupled by a shameful marketing program to support the market blinded brokerages from their fiduciary responsibilities.

Chairman Frank, the ball is in your court.

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