On March 29th, UBS began to lower the values of auction-rate securities held by its clients, a move that will be an unpleasant surprise to investors who had been told they were investing in a safe cash alternative.
Swiss-based UBS is the first major brokerage firm to make this move and they will inform their clients via their online statements. Auction-rate prices will be marked down from a few percentage points to more than 20 percent. Other brokerage firms are expected to follow UBS and several are waiting for the end of the quarter in the coming week to make the decision.
Regulators are also responding. On the same day UBS made its announcement, Massachusetts subpoenaed UBS, Merrill Lynch, and Bank of America for documents related to sales of auction-rate market securities to determine whether individual investors were properly informed of the securities’ illiquid risks.
More than $300 billion of auction-rate securities are held by investors ranging from mutual funds and big institutions to wealthy individual investors. Auction-rate securities are long-term bonds that investors could sell at auctions that took place every week to a month and the interest rates are reset at the time of auction. Investors who wanted a safe and liquid cash alternative were attracted to auction-rate securities since they paid higher yields than traditional savings or money-market accounts. Since the beginning of this year, the auctions have failed to attract buyers and investment banks have refused to step in and finance these securities, leaving investors strapped for cash.
Investors stuck holding these securities are saying they were misled and not warned about the risks in auction-rate securities. Investors are also questioning the accuracy of the models that will be used to price the securities. Wall Street firms often use computer models to price securities that don’t trade often, so how will they price the market when the market does not exist?
Investors will learn the bad news isn’t over yet. Until now, investors were told their auction-rate securities aren’t selling but they would retain their full value. However, UBS confirmed that it will mark down the value of the securities and UBS isn’t offering to buy the securities at the new prices either. Beginning in April, UBS will reclassify the securities from cash alternatives to fixed-income investments instead. Meanwhile, Marten Hoekstra, head of wealth management at UBS for the Americas, says this is in “the best interest of clients to provide them with full transparency in their accounts. Given current market dislocations, this is the next natural step for any committed wealth manager.”
Hoekstra said only 13 percent of the securities would retain their full value and more than two-thirds would see small cuts in value, ranging up to 3 percent. Investors holding auction-rate bonds issued by municipalities, schools and others will have to wait for natural buyers to return to the market before auctions return to normalcy.
UBS would not disclose the total value of auction-rate securities held by its clients, but they say it is concentrated among wealthier clients. The bank’s U.S. wealth management unit oversaw about $743 billion in client assets at the end of 2007.
Other brokerage firms have either declined to comment or said they won’t make a decision on whether to take similar action until March 31st. But last month, Merrill Lynch told their clients that the company will report auction-rate securities at an “estimated” market price and would use outside pricing services to value the securities. However, Merrill did not mark down any securities last month or this month.
The U.S. District Court in Manhattan has sued UBS, Deutsche Bank AG, Merrill Lynch, Morgan Stanley and Citigroup for allegedly deceptive marketing of auction-rate securities. More lawsuits are expected over the coming weeks, and in general, they are alleging that the banks improperly marketed the auction-rate securities as a safe place to invest their money for the short term and failed to inform investors of the risks.
The firms have denied any improper conduct and said they are working with clients on a case-by-case basis to address investors’ frozen assets. UBS and Morgan Stanley have both said they are exploring various alternatives like loans.
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