Investment Banks Sold Auction Rate Securities While Warning Issuers

In a revelation that will further damage the securities industry’s tarnished reputation, Bloomberg reports that Wall Street firms were touting auction rate securities to retail buyers as a safe investment at the same time it was warning issuers that the market was on the verge of serious trouble.

Normally, investor disputes with brokers are subject to arbitration agreements, and some contend that forum is biased towards securities firms. However, there are sometimes grounds for pursuing litigation even with an arbitration agreement in place. The Bloomberg story does not discuss how this might play out, but mentions in passing that class action suits are in process.

From Bloomberg:

Yanping Cui, 57, says she invested in auction-rate bonds last December at the urging of a broker at UBS AG in Long Beach, California. The same month, UBS told one of the issuers of those securities, a New Hampshire student-loan agency, that the $330 billion market was in danger of failing….

Cui is one of dozens of investors who say they were sold auction-rate securities as a low-risk alternative to cash at the same time underwriters, including UBS and Citigroup Inc., were telling issuers that demand was softening, bond documents and interviews with investors show….

At least 24 proposed class-action lawsuits have been filed against brokerages since March, and a nine-state task force is examining how the firms marketed the securities.

This bit is priceless:

Bank of America spokesman Matt Card said the bank doesn’t discuss individual cases. The Charlotte, North Carolina-based bank, like other firms, has offered loans to clients stuck in the securities who need money immediately.

I’m sure the financial institutions regard this as a generous accommodation, but unless the interest rate on the loan is equal to or less than the interest rate on the frozen ARS, I’m sure most investors are incensed that the firms are offering a remedy that provides them with even more income.

Back to the story:

In November the Illinois Student Assistance Commission approved raising the penalty interest on its $880 million of auction-rate debt on the advice of Zurich-based UBS, said executive director Andrew Davis.

UBS had been telling officials for several months that investors wanted to be paid more interest to own the Springfield, Illinois-based student lender’s auction-rate bonds, Davis said.

“No one wanted to be the first guy to have an auction fail,” Davis said. “The thinking was if we paid that much more interest there would be demand, and it would give the market time to heal itself.”

Some securities filings didn’t disclose the new penalty rates and their implications of turmoil in the market until March, after buyers like [investor Jimmy] Walker and Cui purchased auction-rate debt recommended by their brokers.

The examples in the story come heavily from UBS. The article also provides anecdotes where investors say they were misled about the terms of the securities.

If these practices were as widespread as the piece indicates, it points to serious failures in controls and procedures. But at this point, is that a surprise?