Auction Rate Securities Cause Uproar among Brokers

Time to think again, it seems as though the auction rate securities ordeal is nowhere near an end - and investors who had been pitched the instruments as cash alternatives will not get their money back.

In the past two weeks, New York Attorney General Andrew Cuomo has succeeded in getting several major Wall Street players - Citigroup, UBS, JP Morgan Chase, Morgan Stanley and Wachovia, among them - to pony up billions of dollars to buy back the auction rate securities they sold to investors. The catch is in the fine print of the agreements orchestrated by Cuomo: The Wall Street firms only have to pay back the auction rate bonds they sold, not the billions more they actually underwrote.

That small detail could have big repercussions for millions of investors holding illiquid auction rate securities bought through mutual fund firms or individual brokers. As reported Aug. 18, 2008 on CNBC.com, a number of regional firms and discount brokerage houses say the blame for the auction rate securities scandal rests firmly with the major underwriters of the securities - Wall Street powerhouse firms that decided to no longer support the auction rate market and dropped out entirely in February.

According to the CNBC article, the Regional Bond Dealers Association, a brokerage trade association, has written a letter to Cuomo and the Securities and Exchange Commission (SEC) in which it claims the real auction rate fraud was conducted by the underwriters of auction rate securities. The Wall Street firms dominated the auction rate market, the letter says, and sold the auction bonds to regional firms and discount brokerages with the promise to hold auctions. The brokers who sold the securities to customers contend they acted in good faith and relied on information about liquidity risks from those underwriters.

And that’s where problems arise. Many regional firms and brokers do not have the financial prowess of major Wall Street banks. Forcing them to buy back auction rate securities from investors at par value could financially bury many of them. The Regional Bond Dealers Association, in its letter to the SEC, said that the only practical solution for making investors whole is to include ARS customers of distributing firms in the settlements with large lead managers.