Over the last week or so we’ve seen many major Wall Street firms take huge hits on Auction Rate Securities. UBS, Lehman (LEH), Merrill (MER) and Morgan Stanley (NYSE:MS) have all agreed to buy back tens of billions of dollars worth of these securities from their clients.
So what are Auction Rate Securities, and what’s the big fuss all about?
Auction Rate Securities [ARS] are typically 30-year bonds that have their interest rates reset by auction every 7, 28 or 35 days. There is no secondary market for them outside of these periodic auctions. Since the 1980’s the ARS market has been quite an efficient one.
Municipalities, education companies and corporations have all used the ARS market as a source of low cost capital. Until 2007, the biggest players in the space were institutional buyers looking for higher rates than could be found in money markets (the ARS market is usually a full percentage point higher than a typical money market fund).
By 2006 and going into 2007, it was pretty obvious to the smart money that a liquidity crisis was on the horizon. After years and years of institutional dominance, the percentage of ARS individual ownership suddenly got very lopsided: By the end of 2007, institutions accounted for just 30% ... with individuals owning 70% of the market.
How was such a massive liquidation orchestrated?
Through good old fashioned stock fraud, that’s how.
We are talking about fraud on a level that would make Al Capone blush. Over 300 billion dollars of illiquid securities were dumped onto investors, and I’m talking about regular people, not just the rich.
The first thing the Wall Street money magicians did was lower the minimum investment from $250,000 down to $25,000 so that Auction Rate Securities would be within reach of individual investors. The second part of the fraud consisted of pitching Auction Rate Securities as cash equivalents. Do you think that they mentioned the credit default risk? Not judging by a criminal complaint recently filed against UBS (NYSE:UBS) by the New York Attorney General's office.
The ARS market is essentially like a massive Ponzi scheme in that it requires new buyers at every auction to provide liquidity. When institutional buyers stopped showing up, the brokerage firms themselves stepped in to provide that liquidity. Essentially it was their buying that propped up the market. Liquidity was entirely dependent upon the firms' buying. Boiler room brokerage houses have been doing this sort of stuff for years, supporting “house” stocks and creating a false market.
The firms knew that this liquidity was a complete fiction, but they still kept on selling the securities to the general public. All the while, they were telling their clients that their money was perfectly safe and liquid.
For an example, just look at UBS. Even after the ARS market had defaulted and seized up, they were still pitching these securities to their customers!
In fact, just a few months before UBS defaulted, several insiders at the firm who were tasked with fixing this problem dumped 21 million dollars worth of Auction Rate Securities from their own portfolio!
(Incidentally, with UBS we're also talking about a company that went out of its way to teach thousands of Americans how to hide their money in Switzerland, at a cost of billions in lost US tax revenue.)
Today, like never before, we can clearly see that the major firms are really just criminal enterprises in drag.
Make no mistake: the actions of Wall Street firms surrounding Auction Rate Securities was criminal. After reading the 40-page criminal complaint issued from New York State Attorney General Andrew Cuomo's office, it’s impossible to view it any other way.
In fact, without Andrew Cuomo’s involvement, the big firms would have done nothing. Why should they? They were receiving 1.5% in underwriting fees, plus ¼% per year for holding the auctions, even if the auctions were unsuccessful! There was no incentive for them to make their clients whole. It took Cuomo and the ten ton hammer called The Martin Act to get these banks in line.
So when are we going to say enough is enough and finally hold one of these big firms morally and financially responsible?
Fining them is a start, but when are we going to have the guts to say to the UBS’s of the world, "get out of our country, you can’t do business here any more"?
How long are we going to let these organized crime outfits rob our citizens?
If we are to take Andrew Cuomo's commitment to fighting crime seriously, then we must see a criminal conviction of one of these major firms. Anything less is an insult to every individual investor who trusted these firms with their hard earned money.