Don Quixote and ARS Investors

Recent articles in The Boston Globe and Bloomberg underscore how Wall Street firms woefully favor their own interests at the expense of individual investors.

According to a report in today's Globe, UBS Financial Services warned some of its big investment banking clients of looming problems in the auction rate securities (ARS) market three months before the market for these securities collapsed. Nevertheless, the firm continued marketing the securities as cash equivalents to unsuspecting individual investors.

Adding insult to injury, the Globe and Bloomberg report that UBS, Bank of America, and Wachovia along with others are preventing their clients from unloading auction rate securities at a loss saying – are you ready for this? – it isn't in their clients' best interests!

In an ideal world, it would be nice to believe that Wall Street firms are actually trying to do right by unsuspecting investors whose brokers assured them that auction rate securities were cash equivalents. But Bryan Lantagne, the securities division director for Massachusetts, offers Bloomberg a more compelling explanation:

"By allowing customers to sell at a discount, the banks allow customers to establish damages."

Richard Stahl, a retired New Hampshire car dealer, is one of the auction rate securities victims caught in limbo. The 73-year-old UBS client wants to sell some $650,000 worth of auction rate securities, but UBS won't let him.

"I feel like Don Quixote fighting windmills," Mr. Stahl told the Globe.

Sadly, Mr. Stahl, compared to taking on Wall Street, Don Quixote had it easy.

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.

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.

When Wall Street Exploits A Charity

Having represented investors who have been wronged by Wall Street for more than three decades, I've seen a lot of scandalous activities. But nothing outrages me more when a brokerage firm seeks to exploit a charitable group. Sadly, I'm dealing with yet another egregious instance, this one involving the peddling of auction rate securities to a charitable foundation in Ohio.

The charity is called the Joffe Foundation, which was founded by Steven N. Joffe, a renowned Cincinnati opthamologist and a pioneer in laser-vision correction surgery. The foundation regularly makes donations and commitments to provide funds on an ongoing basis to support various charities and causes, including low-income patients in the US in need of laser vision correction; AIDS prevention; high school educations; and surgeries to correct cleft palates in children in South Africa and Ghana. Because of its ongoing funding commitments, the Joffe Foundation made clear to its broker at UBS Financial Services that it needed to keep its funds extremely safe and liquid.

But the foundation's UBS broker wasn't content having the organization park its money in a simple money market account. Instead, he encouraged it to purchase auction rate securities, which he assured Dr. Joffe were "the equivalent of cash" and could be liquidated within a few days if necessary.

Auction rate securities are long-term government or corporate bond instruments where the interest rates are set at weekly or monthly auctions. As long as there are investors willing to bid on the bonds, they are indeed liquid investments paying higher rates of interests than money market accounts. The problem is that if there aren't enough investors to buy the bonds, the auctions fail. Investors holding the paper are suddenly stuck with a long-term note with a "penalty" interest rate predefined by the bond's issuer.

Making a market for auction rate securities was a highly lucrative $330 billion market for the big Wall Street firms, including UBS. But the balance sheets of the big firms have been badly impaired because of the collapse of the mortgage-backed securities market (a crisis of their own doing), so they no longer have the wherewithal to support the auction rate market. That's why the market for auction rate securities has dried up.

Acting on his broker's insistence that auction rate securities were as good as cash, Dr. Joffe agreed to allow UBS to invest the foundation's entire $1.35 million. UBS invested all the money in various ARS series or issues of preferred stock in the Eaton Vance Limited Duration Fund, thereby increasing the Joffe Foundation's risk because all its auction rate securities investments were tied to that fund.

The auction for the Joffe Foundation's securities failed on Feb. 15, so all its cash is locked up indefinitely. Although the penalty interest rates of failed auction rate securities can sometimes go as high 17%, the penalty rate on the Joffe Foundation's paper is a measly 4.97%. That makes it incredibly unlikely that anyone will buy the paper before it matures. Moreover, the Eaton Vance fund itself carries enormous potential risk of principal loss.

As a result of this debacle, the Joffe Foundation cannot make a committed $100,000 donation to laser vision correction patients, nor fund its ongoing commitments. The foundation also needs cash to fund the salary of its administrative assistant.

Zamansky & Associates has already filed an arbitration claim on behalf of the Joffe Foundation, but it will take some time before it can be heard. You might think that UBS, which likely earned tens of millions of dollars peddling auction rate securities, would do right for a worthy charity and rescind the fraudulent and unsuitable investments so the foundation can honor its donation commitments, but unfortunately you would be badly mistaken.

Financial Regulators Missed the ARS Market, But That’s Par for the Course

I can’t help but note the irony of David Brown, executive director of the New York State Dormitory Authority, lambasting Wall Street for allowing the collapse of the auction rate securities market.

“As a whole, this is not the finest hour of the investment-banking community,” the Wall Street Journal quoted Mr. Brown as saying. Auction dealers “are refusing to make a market in the securities, saying publicly the product is dead and everyone has to get out of it,” then recommending debt restructurings “where they will earn yet another investment banking fee.”

I applaud Mr. Brown for sounding his criticisms, as I already have voiced the same concerns. But let’s be honest here: As a whole, this also isn’t the finest hour for regulators and some former prosecutors, including Eliot Spitzer, who served as New York’s attorney general before being elected governor.

Mr. Brown was a deputy attorney general under Mr. Spitzer. He was the person who spearheaded a probe of mutual fund trading abuses that ultimately resulted in some $3 billion in fines. There’s no questions that is a severe penalty, but regulators gave a pass to the executives ultimately responsible for the wrongdoing. To Mr. Spitzer’s credit, he at least took some action to punish the mutual fund industry for its improper market timing trading; the practice was well known and reported in 1997 by then Wall Street Journal reporter Charlie Gasparino (no link available), who quoted SEC officials as saying they would investigate the matter. The agency did nothing until Mr. Spitzer stepped in.

But imposing fines on Wall Street firms has hardly proven to be a deterrent for Wall Street, particularly since most of the penalties are puny to begin with. The SEC in 2006 charged 15 Wall Street firms with wrongdoing relating to auction rate securities and let them off with a $13 million fine, which didn’t even constitute a wrist slap. So no one should be surprised that some of the wrongdoing continued. Wall Street executives regard regulatory and prosecutorial fines as simply the cost of doing business.

Wall Street cannot be reformed until regulators and prosecutors begin taking legal action against the top executives at the major firms. Most, if not all, the top Wall Street executives knew about market timing and it’s highly unlikely there weren’t aware of the wrongdoing taking place in the auction securities market. Federal prosecutors have done an impressive job garnering convictions of CEOs and other top executives at companies involved in wrongdoing; if Mr. Brown laments Wall Street’s ways, his criticisms should also be directed at the SEC and Mr. Spitzer.

Auction Rate Securities Round-Up

The financial media is moving the needle forward with regard to the auction rate securities crisis. Both the New York Times and Dow Jones have interesting takes today:

• Floyd Norris reports that auctions continue to fail and that municipalities as a result will likely pay more to borrow money. The article reports that that some auctions - such as those issued by leveraged municipal bond funds - are in dire straits.

• Dow Jones reports that as far back as 1992, auction rate securities triggered arbitration panels to award claims to investors. An arbitration panel awarded an investor group $2.2 million siding with them over Goldman Sachs who allegedly hid the risk associated with ARSs. A second, separate arbitration award was later granted to an investor with similar claims.

Arbitration awards as far back in 1992 are significant. Recall that it wasn’t until 2006 that the SEC made its illusionary attempt to reform the auction rate securities market. With evidence of alleged widespread bid rigging and arbitration awards due to inadequate risk disclosures, regulators turned a blind eye to what has developed into a $350 billion debacle.

Auction Rate Securities: A Scandal Made Possible by the SEC

The SEC's Division of Enforcement has never been considered a tough minded regulator. But the collapse of the auction rate securities market underscores just how frighteningly ineffective the division really is.

On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. Here's an excerpt from that release:

The SEC order finds that, between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included

• allowing customers to place open or market orders in auctions;

• intervening in auctions by bidding for a firm's proprietary account or asking customers to make or change orders in order to


• prevent failed auctions, to set a "market" rate, or to prevent all-hold auctions;


• submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;


• not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;


• having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and


• providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The release also noted:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities (emphasis mine). By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.

In justifying the paltry $13 million fine the SEC imposed, a spokesperson said the agency "considered the amount of investor harm and the firms' conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations." In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff's request for information, which allowed the SEC to conserve resources.

With the advantage of hindsight, it's clear that the SEC never understood the inherent and significant damage that was created by brokerage firms rigging the auction in the first place. It's also worth noting that if Wall Street firms simply cooperate with the SEC that partially justifies a wrist slap. Finally, if SEC still mistakenly believes that the their "cease and desist" order prompted the big brokerage firms to warn investors of the risks in buying auction rate securities, I have some clients they should definitely meet.

Auction Rate Securities: An Investor Scandal of Significant Proportions

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were "serious and widespread."

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as "investments" rather than "cash equivalents." As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.