ARPS Scandal: Banks Must Rebuild Investors' Trust

NOW THAT NEW YORK Attorney General Andrew Cuomo and other regulators have put a gun to their heads, the big Wall Street firms are finally coming clean about the collapse of the auction rate securities market.

The truth is even uglier than I suspected, and I've been beating the drum over this issue for months.

Auction rate securities were sold by nearly all the big firms as a slightly higher-yielding, but safe, alternative to money-market funds. They proved anything but when the auction markets froze in February, stranding thousands of investors with more than $300 billion in illiquid holdings. As readers of this column know, I was among the victims. I've since heard from hundreds of others, many of whom suffered hardships when the cash they counted on to pay taxes, to finance home purchases and college educations, and to meet payrolls proved inaccessible. Wall Street's reaction, as I've reported, was to offer to loan investors their own money — using our other assets as collateral and charging us market rates. It was insult on top of injury.

It's not like we were clamoring to buy these securities for the modest interest rate premium they offered. Like the other victims I've heard from, I got a call out of the blue urging me to take advantage of an offer that was being extended to valuable clients.

My pleas to Wall Street firms to simply do the right thing and reimburse their clients (see my May 2008 magazine column) went unheeded. Representatives of firms I spoke to either refused to comment or said their balance sheets, already under strain from the credit crisis and their own lending practices, couldn't support such a move. They also maintained that they, too, were victims of an unforeseeable crisis.

Now we know that none of this was true for at least some of the biggest firms. Thanks to a wave of subpoenas, lawsuits or threatened lawsuits, and the prospect of public disclosure, three of the biggest sellers of auction rate securities agreed last week to reimburse the clients they purported to value so highly. Citigroup (C) led the pack by reaching an agreement with Cuomo and the Securities and Exchange Commission last week to stave off a lawsuit. Merrill Lynch (MER) also under investigation, announced that it would reimburse clients. And UBS (UBS) settled a pending lawsuit by agreeing to reimburse clients and pay a $150 million fine. Those firms said they will buy back a total of nearly $40 billion in the securities, a sum that, while large, can indeed be absorbed by their balance sheets.

What's really shocking are the allegations and evidence that UBS and Citigroup executives knew that the auction rate market was about to collapse even as they pressed their brokers to push the product on unsuspecting clients. Put more bluntly, the evidence suggests they weren't the victims of unforeseen events — they perpetrated them.

The New York Attorney General's complaint (available here) against UBS is a withering portrayal of what Cuomo calls a "multibillion-dollar consumer and securities fraud." At UBS, top bank executives unloaded over $21 million of their own personal holdings of auction rate securities as they realized the market was in trouble, the complaint alleges. In December 2007, UBS's trading desk manager sent an email to the global head of municipal securities saying "The auction product does not work." Other emails referred to the auction rate securities as a "huge albatross" for the firm and a "scary and delicate" situation. Yet the firm kept peddling them to clients. Within "hours" of learning of trouble in the auctions, one UBS executive instructed his personal broker that "I want to get out of arcs [auction rate certificates]," and sold off all $250,000 of his holdings. Over 50,000 UBS customers ended up owning more than $37 billion of the illiquid securities, according to the complaint. Cuomo characterized UBS's actions as a "flagrant breach of trust."

Katrina Byrne, a spokeswoman for UBS, responded: "We categorically reject any claim that the firm engaged in any widespread campaign to move auction rate securities inventory from our own books into private client accounts." As for the emails, she said, "We were disappointed the New York Attorney General released details on certain transactions when we conducted our own internal investigation with the assistance of external counsel. We found no evidence of unlawful conduct by any employees." She added that "there may have been cases of poor judgment," and said UBS is evaluating what, if any, disciplinary actions might be appropriate.