It's Time To Re-regulate Business

08/12/2008 05:12 am ET | Updated May 25, 2011

Merrill Lynch & Co. was accused by Massachusetts Secretary of State William Galvin of misleading investors about the stability of the auction-rate market at the same time the investment bank was marketing the securities.

New York-based Merrill ``co-opted'' its research department to help place the securities with customers, Galvin said in a statement from Boston today. The state's administrative claim asks the third-largest U.S. securities firm to ``make good'' on sales of now-frozen holdings, compensate investors who disposed of their bonds or shares at a loss and pay an unspecified fine.

``This company was aggressively selling'' the securities ``and its auction desk was censoring the research analysts to make sure they downplayed'' risks in the market, Galvin said in the statement. ``They knew the auction markets were in trouble, but the investors were the last to know.''

Wachovia Corp.'s securities division was inspected by a team of regulators from more than five states who delivered subpoenas today as part of a probe into the company's sales of auction-rate bonds.

Investigators searched the unit's St. Louis headquarters to seek information about sales practices, internal evaluations of the auction-rate securities market and marketing strategies, Missouri's Securities Division said in a statement. More than a dozen subpoenas were issued to Wachovia executives and agents.

As much as $218 billion of auction-rate bonds sold by student-loan providers, municipalities and closed-end mutual funds remain frozen after firms abandoned their role as buyers of last resort in February. Regulators in Massachusetts last month sued UBS AG for fraud, claiming it told investors the bonds were safe and liquid.

Federal prosecutors are investigating whether two former Credit Suisse (CS) brokers lied to investors about how they placed their money into auction rate securities, a type of bond investment that has hurt investors, reports the Wall Street Journal. The $330 billion market for auction rate securities allows issuers such as municipalities and student loan companies, closed-end mutual funds or financial institutions to borrow money in the form of long-term bonds. The market has treated these bonds like safe, short-term investments because investors can sell them at weekly auctions. But the auction market for these bonds dried up when the credit crisis hit, and investors were trapped in these long-dated securities because there were no buyers.

On Thursday 24 July, New York State Attorney General Andrew Cuomo filed charges against UBS Securities and UBS Financial Services (collectively UBS), accusing the Swiss bank of a "multibillion-dollar consumer and securities fraud".

The allegations centre on the sale of auction-rate securities (ARS), which are shares or debt instruments for which the interest rate is reset at regular intervals, and which were marketed by the bank as being so liquid they were equivalent to cash.

A statement from the Attorney General's Office says UBS has been "falsely selling and marketing auction-rate securities as safe, highly liquid and cash-equivalent securities".

It adds that these representations were deceptive, "as the ­auction-rate securities market came under tremendous strain, leaving the ­securities with mounting ­liquidity risks that eventually blocked thousands of customers across New York and the nation from accessing their holdings".

According to the Attorney ­General's Office, UBS customers have been left holding more than $25bn (£12.63bn) in illiquid, long-term paper as a result of the bank's "fraudulent misrepresentations and illegal conduct".

First -- what is an auction rated security?

A debt security that is sold through a dutch auction. The auction rate security (ARS) is sold at an interest rate that will clear the market at the lowest yield possible. This ensures that all bidders on an ARS receive the same yield on the debt issue.

The interest rate is reset periodically.

In essence, an auction rate security is a long-term debt issue, but it acts as if it were a shorter term issue. This is because interest rates are reset approximately every month, depending on whether the issue is tax exempt, and the interest is paid either shortly after the auction yield is settled or every quarter or half year.

The reason for this market is simple. Short term interest rates are usually lower than long term interest rates. Therefore, borrowers want to borrow at the short-term rates even when they are actually borrowing at long term. Enter a net-work of securities dealers who helped to make that happen. Borrowers would in fact borrow long-term -- 20+ years. However, every month or so they would hold an auction that would reset the rates on their debt at various short-term rates. If there were no bids for a particular security one of the dealers (a large money center bank or investment bank) would purchase the security knowing they could resell it at the next auction within the next few months.

Enter the credit crunch. This essentially killed the auction rate market. Central to this market was the liquidity the investment banks provided. When the credit crunch hit, the banks were no longer able to purchase debt that could not be sold. In effect, liquidity dried up. That means the auction rate market died.

But as the examples above indicate, the investment banks pretty clearly crossed legal and ethical lines. Four different states are bringing charges against four different firms. Those facts tell us sometime pretty important: the problems were side spread within the industry, meaning a lot of people were probably doing something they shouldn't have been.

As the credit crunch plays out, one central theme is becoming very obvious: deregulation has gone way too far. Without rules and regulations -- and someone enforcing those rules fairly across the board -- things go to far way too quickly.