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Auction-Rate Crackdown Widens

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By: Liz Rappaport | July 24, 2008

UBS Faces new Charges in New York, as Scrutiny of Wall Street's Role Intensifies

The state of New York has joined a widening array of prosecutors and customers accusing Wall Street firms of wrongdoing in efforts to hold together the $US330 billion ($346 billion) auction rate securities (ARS) market before it collapsed in February.

State Attorney-General Andrew Cuomo yesterday filed civil fraud charges against UBS, accusing the firm of a "multi-billion-dollar consumer and securities fraud" and demanding that the firm pay back its profits from the business, make investors whole and pay damages.

A spokeswoman for UBS said: "We will vigorously defend ourselves against this complaint." The New York attorney's case echoes a similar case brought against UBS by Massachusetts officials and many private cases and arbitration claims filed against UBS and other prominent firms in recent months.

The firms are accused of pushing risky securities on retail and corporate customers with misleading sales tactics, even as the market for those securities was falling apart. When the collapse came, many customers faced losses or were stuck with securities they could not sell.

Wall Street firms themselves have suffered immense losses and faced litigation resulting from their activities in other kinds of troubled financial instruments -- most notably mortgage-backed securities. Their auction rate problem could prove a smaller financial scar than the hundreds of billions lost in mortgage-backed securities, but a big loss to Wall Street's reputation.

The victims in the auction rate cases range from individual investors to big corporations. Some 250 public companies held these instruments, as did tens of thousands of individuals. The companies -- ranging from 3M to Texas Instruments -- have on average written down the value of these holdings by 12 per cent in the past few months, according to Pluris Valuation Advisers, a company that helps corporations value illiquid securities. Applied across the whole $330 billion market -- which since February has shrunk drastically -- that would amount to roughly $40 billion of losses.

Auction rate securities -- issued by municipalities, student-loan companies, charitable organizations and others -- are long-term securities that Wall Street engineered to have short-term features. Their interest rates reset at weekly or monthly auctions run by Wall Street firms. The firms assured individual investors and corporate clients that the frequent auctions made these securities as safe and liquid as cash because they would always be easy to sell quickly.

At the root of these cases is a common allegation: as problems mounted in these auctions and their own inventories of these securities became bloated, Wall Street firms worked aggressively to push the instruments out of their doors and into the hands of clients, playing down the severity of the problems rippling through the market.

The action, Mr. Cuomo and others charge, helped to contain their own losses but left their customers with beaten down, illiquid investments.

The New York complaint also alleges that several high-ranking UBS executives, whom the New York attorney did not name, sold roughly $21 million of their own auction rate securities holdings amid the turmoil. Some 50,000 UBS customers were left holding $37 billion worth of the struggling investments, the complaint says.

Karina Byrne, a UBS spokeswoman, said: "UBS does not believe that there was illegal conduct by any employee." After an internal investigation into personal sales of auction rate securities, "we have found cases of poor judgment by certain individuals and are evaluating appropriate disciplinary measures for these individuals," she said.

"It is frustrating that the New York Attorney General has filed this complaint while we have been fully engaged in good-faith negotiations with his office to bring liquidity to our clients holding auction rate securities," she added.

UBS is at the centre of many of these allegations, but it is not alone. Investigators from 10 states showed up at the offices of Wachovia's St Louis brokerage offices last week to get documents and conduct interviews in a dramatic escalation of their probe into its auction rate activities. Wachovia said it, like others, was responding to inquiries from regulators.

State attorneys are also probing the activities of Merrill Lynch, Citigroup and others. Merrill Lynch and Citigroup declined to comment.

The securities are backed by pools of other financial instruments, such as student loans, ultra-safe municipal bonds or complex sub-prime mortgage debt. Even the safe municipal bonds were drawn into the unfolding mortgage crisis because they were backed by struggling bond insurers with exposure to mortgage debt.

In normal times, when weekly auctions of auction rate securities failed to generate sufficient demand, Wall Street firms stepped in to support the market, buying the instruments themselves. But as they became strained by other problems, Wall Street firms stopped supporting the market with their own bids. By February, nearly every auction was not drawing enough buyers and the securities suddenly became illiquid, impossible for investors to cash in.

In February the market collapsed when the big dealers -- including UBS, Citigroup, Merrill and others -- stopped supporting struggling auctions, leaving investors unable to sell. Many companies have had to mark down their value, individuals have been stuck unable to access cash, and issuers of the instruments have had to pay higher interest rates or find a new way to raise money.

Before it fell apart, Wall Street firms raised some brokers' commissions to get the securities out of the door. Merrill Lynch published reassuring research just days before it pulled out of the market. At UBS, executives mobilized its financial advisers to sell the securities to institutional and retail investors, many of whom have since filed complaints alleging UBS and others offered sugar-coated assurances in the months leading up to the February collapse.

One example unearthed in the Massachusetts investigations: last November, Edward Hynes, an institutional sales manager at UBS, was preparing for a conference call with salespeople who worked directly with investors. In an email to three colleagues who would be leading the call, he laid out a strategy for the message that salespeople should take to UBS clients, according to documents filed by the state of Massachusetts against UBS.

"We need them to walk out and believe that this is a strong credit w (sic) strong UBS commitment to support the liquidity," Mr. Hynes wrote in an email to several colleagues about auction rate securities backed by student loans, according to the Massachusetts case. At the time, the market was still a few months away from breaking, but cracks were already showing up. Mr. Hynes is not named in the New York complaint.

People familiar with the email say the call would have been with institutional sales people, not retail investment advisers.

"We are not going to address specific emails taken out of context," Ms. Byrne said. "UBS has acted in clients' best interests in this matter."