The Auction Rate Bonds Mess: To the Depths of Depravity and Beyond!

09/12/2008 05:12 am ET | Updated May 25, 2011

Remember the analyst fraud scandal? Major brokerage firms agreed to a $1.4 billion fine to settle charges that their research misled retail investors. At the time, the finest PR firms and lobbyists in the world assured investors that Wall Street had "cleaned up its act". We heard a lot about a "Chinese wall" that was supposed to protect analysts from being pressured to enhance the ratings of institutional clients.

Trusting investors bought the pitch and returned to the warm embrace of this disgraced industry in droves.

Fast forward five years.

UBS, Merrill Lynch and Citigroup have announced settlements with regulatory agencies that will require them to purchase $40 billion of auction rate bonds held by their retail clients and to pay substantial penalties. Other firms are under investigation and are likely to agree to similar settlements.

In the analyst fraud cases, the firms never agreed to make restitution to their clients. They got off cheap, secure in the knowledge that the FINRA mandatory arbitration system would protect them from any meaningful awards. Their trust in this flawed system proved to be right on the money.

What's different now?

The evidence of total depravity and greed by the securities industry in misleading investors about the relative safety of these bonds is so overwhelming and disturbing that the industry hopes to quickly sweep this issue under the rug. Clearly, if investors understood how they are used as cannon fodder to generate profits, their confidence would be completely undermined.

The Elliott Ness of securities regulators is William Francis Galvin, the Secretary of the Commonwealth of Massachusetts. Galvin has been a leader in aggressively going after Wall Street firms that plunder the savings of investors using deceptive and unfair tactics. He has had no shortage of ammunition.

On July 31, 2008, Galvin's Office brought an Administrative Complaint against Merrill Lynch. It set forth the details of Merrill Lynch's sordid conduct in connection with auction rate securities. The e-mails detailed in this complaint provide insight into the motivations of your "trusted financial professionals."

One analyst had the temerity to question the liquidity of these bonds. After a flurry of internal e-mails, he was asked to change his opinion and endorse these securities "as a buying opportunity for investors..."

When another analyst was answering questions about auction rate securities in a conference call with retail brokers, his boss e-mailed a message ordering him to be "shut down" because he was not being positive enough.

When the market showed clear signs of failing, Merrill Lynch was undeterred. In one particularly sickening e-mail, a Merrill Lynch executive brushed off the signs of market distress by cryptically noting "Gotta Move these microwave ovens!!"

On February 12, 2008, Merrill Lynch stopped supporting its auction bonds and many of the auctions failed as a result. Yet, only 5 days earlier, the retail brokers were told that "Merrill Lynch certainly by all indications, is committed to this product."

The Administrative Complaint alleged that "[W]itness testimony before the Division confirms that Merrill Lynch's decision to stop broadly supporting its auction program was made without any consideration or analysis of its effect on retail or other customers holding these securities."

Do you really have to wonder why retail investors were tossed under the bus?

Could it be.....fees?

The Complaint alleged that "Merrill Lynch reaped a total of approximately $90 million dollars in total profits" from its auction rate program in 2006 and 2007 and that it "...had a significant interest in keeping its issuer clients happy in hopes of securing future business with those clients."

Sound familiar? Just like the analyst scandal, the interests of the average Joe were sacrificed to keep those big fees rolling in.

There is a fine line that separates the admirable quality of forgiveness from the sad one of being a sucker. When you consider doing business with these firms, you need to decide which side of that line you are on.

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