ARS Boys Under The Hammer

The auction-rate securities farce continues at a pace with more indictments, but this time it involves individuals in trouble rather than entire banks.

Federal prosecutors in Brooklyn filed charges against two former Credit Suisse brokers, Julian Tzolov and Eric Butler, for fraud in the sale of auction-rate securities to CSFB customers. Meanwhile, the SEC followed up with its own civil suit against the duo. Click here for the DOJ’s press release; here for the indictment; and here for the SEC’s complaint.

The indictment alleges that Tzolov and Butler schemed to obtain higher sales commissions by selling auction rate securities backed by mortgages to Credit Suisse clients who, in fact, had placed orders to buy ARS backed by student loans.

The defendant are said to have lied to clients and their employer by falsifying the names of the ARS the clients bought and otherwise misleading the clients into believing they had bought ARS backed by student loans. When the mortgage-backed ARS market failed, say prosecutors, the clients lost their money.

Looks like Tzolov, however, is not hanging around for the result as he is suspected of fleeing back to his native Bulgaria.

FBI Assistant Director-in-Charge Mark Mershon stated, “Investors who were told they were purchasing relatively low-risk securities backed by student loans were unwittingly purchasing high-risk mortgage-backed securities. For a nearly three-year period, what Tzolov and Butler sold their clients was a bill of goods. The FBI remains committed to policing the securities industry to protect investors from all forms of unscrupulous and illegal conduct.”

No comment has come from the defendants or their lawyers at this stage.

This, we are sure, is not the last we will have heard on the whole ARS thing nor on the hedge fund blow ups.

We wrote previously here about hedge fund rules and how they do not represent sanity when approaching this market. Although the ARS situation is a little different we do believe that reforms on hedge fund advertising and access rules could go a long way to preventing fraudulent situations occurring.

If hedge funds were able to advertise (therefore have informative web sites and information) clients would be able to evaluate those funds that perform well, those that don’t and those that are a scam. In 2007 hedge fund manager Phillip Goldstein sent the performance of his fund to a client who never actually invested. He was indicted under the hedge fund advertising rules but won his case against the SEC.

We hope the regulators will look at the various frauds and misleading situations that have happened over the last few years and look inward to assess whether the rules now need to be overhauled and brought into some semblance of sanity.

UBS Face $25bn Bite In The ARS.

If all wasn't already bad enough for the beleaguered UBS, things are now starting to get serious. Facing prosecution in the US for various charges of aiding tax fraud the US authorities also threw in a charge of fraudulently selling auction-rate securities.

UBS is close to resolving those claims and may make a promise to retail and institutional clients to buy back the securities, valued at $25 billion by regulators.

On Thursday, Citigroup agreed to buy back about $7.5 billion of the debt, as part of settlements with New York Attorney General Andrew Cuomo and the U.S. Securities and Exchange Commission.

Zurich-based UBS, the target of three state complaints over auction-rate sales, has been in talks this week with Massachusetts, Texas, New York and the Securities and Exchange Commission in an effort to settle the claims.

"We are consistently working with regulators towards a comprehensive solution for all auction-rate securities investors," UBS spokeswoman Sabine Woessner told Reuters, but declined to comment on the report.

(Definition - Wikipedia) An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction.

It could also refer to a preferred stock for which the dividend is reset through the same process. In the dutch auction, broker-dealers submit bids on behalf of potential buyers and sellers of the bond. Based on the submitted bids, the auction agent will set the next interest rate as the lowest rate to match supply and demand. Since ARS holders do not have the right to put their securities back to the issuer, no bank liquidity facility is required

The market started to fall apart Beginning on Thursday, February 7th, 2008. Auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with these own firm's need to protect their capital during the 2008 financial crisis.

On February 13 (2008) 80% of auctions failed. On February 20th, 62% failed (395 out of 641 auctions). As a comparison, from 1984 until the end of 2007, there were a total of 44 failed auctions.

On March 28th, 2008, UBS AG said it was marking down the value of auction-rate securities in brokerage accounts from a few percentage points to more than 20%. The markdowns reflect the estimated drop in value of the securities that the market has seized up, while UBS wasn't offering to buy the securities at the new lower prices.

Beginning in March 2008, several class action lawsuits had been filed against several of the large banks. The lawsuits were filed in federal court in Manhattan alleging that these investment banks deceptively marketed auction-rate securities as cash alternatives.

On July 17th a National Task Force, be made up of officials from several states including Missouri, began investigating at the St. Louis, MO Headquarters of Wachovia Securities. Some in the media were calling it a raid and officials called it a "Special Investigation" at the St. Louis offices. Media reports also said that Wachovia Securities part of Wachovia Corp based in Charlotte, NC did not comply with request by officials which prompted the "Special Investigation".
It is also stated that other Securities Firms are also a part of the investigation. The Missouri State action was prompted by complaints to the state and total of more than $40 million of investments that were frozen.

Citi then announced it would be buying back these securities and now UBS looks to be negotiating a similar situation.

It is a tough time to be a banker, especially one with UBS, we just hope that certain commentators, who have been calling the bottom in the banking sector, are right!