From the WSJ: UBS Cutting Value Of Auction-Rate Securities In Brokerage Accounts

UBS is the first of what will surely be many large banks to pass losses on Auction Rate Securities on to their customers. Of course these are the same customers who were told that these investments were as liquid and as safe as cash.

The Money Quote:

“Some Clients Will Face Losses on Paper Of More Than 20%”

We’re all Charlie Brown now

“Everybody talks about the weather, but nobody does anything about it.” – Mark Twain

I had been trying to get my head around this whole issue with Auction Rate Securities. Once again, the Time’s Gretchen Morgenson covers the basics of another investment shell game in her March 9^th article: As Good as Cash Until it’s Not.

Ms. Morgenson classifies the misrepresentation of Auction Rate Securities as a Wall Street problem: “The investments, which Wall Street peddled as a cash equivalent, are known as auction-rate notes.” As a former ethically inflexible broker myself, my perspective is that this is just another example of rewarding unethical, and most certainly illegal, behavior on Wall Street. By classifying it, incorrectly, as a Wall Street problem, the article takes an editorial stand that the Auction fiasco in not the result of unethical and most likely illegal, behavior but standard Wall Street operating procedure.

Isn’t fraud a common law principle still contained somewhere in the American legal canon? I’m sure the Times isn’t asserting that fraud is standard operating procedure on Wall Street.

Broker Example:

Broker A: Our Money Market Yields 3.5%

Broker B: Our Money Market Equivalent yields 4.5% (never revealing the, now realized, pitfall of zero liquidity)

Allow this behavior for too long and eventfully Broker A will be either be out of business or begin changing his ethics he can compete with Broker B.

On the other side of these transactions are hundreds of municipalities. Similarly caught in this Interest Rate shell game, these municipalities are facing situations analogous to a mortgage borrower with a 7, 14 or 28 day ARM.

Investment Banker Example:

The town of Springfield is trying to build a monorail and needs to raise $30 million dollars.

Investment Banker A: Offers to issue $30 million in 10 year fixed bonds @ 6%

Investment Banker B: Offers to issue $30 million 10 year Auction Pfds @ 4%

Just as Broker B does in the previous example, Investment Banker B never emphasizes the con, only highlights the pros, of these Auction securities. The con being that if no one buys at the next auction the Investor loses liquidity and the Issuer (municipality) gets the exorbitant penalty rate.

Of course prior the recent failed actions (70% failure by some estimates), the Investment Banker assures Springfield that the weekly or monthly auctions have been successful for three decades and the exorbitant failed auction rates, possibly as high as 20%, are only just so much legalese. Just like fraud, I’m pretty sure the word fiduciary is still in our legal cannon.

The Time’s article acknowledges that investors were intentionally misled:

“In interviews, investors who own these securities say they weren’t warned that they might not be able to sell them if an auction failed. They say they were told that the instruments were as safe and liquid as — yes, you guessed it — cash.”

No mention is made of any investors who knew the true nature of these investments. It seems that all current investors are the poor schmos who order the fish of the day not realizing it’s really the fish that went bad yesterday. Most likely, informed investors were smart enough to exit this market months ago.

Neither is there any mention in the Time‘s article of any informed brokers who advised their clients to exit this market in the months preceding their failure. I guess there’s a thin green line preventing them from outing their corrupt brethren.

Of course these tactics not only allow the less informed ,or less ethical brokers, and investment bankers to steal business from the better informed and more ethical, it also happens to generate hugely exorbitant fees. Again Ms. Morgenson notes:

“Wall Street made generous fees issuing these securities and running the auctions — as long as there were bidders. After the bidders vanished, some firms stepped in and bid for the securities for a while, giving investors a way out.

No more. What’s the sense stretching your already-thin balance sheet just to keep a market open for your customers? “

A favorite of marketers is the term built in obsolescence. Take a product that lasts for years and turn it into a product that has to be repurchased every couple of weeks; sharpening a straight razors sucks…get a new blade for your Mach 3 every two weeks.

Someone must have realized that a 30 year bond issued at a fixed rate once at inception doesn’t generate as much fees as a 30 year issue that needs to be reissued every week or month.

This behavior makes an investor want to learn how to use a straight razor like a certain Sweeney Todd.

Ms. Morgenson asserts, hopefully incorrectly, that Broker B and Investment Banker B are representative of all of Wall Street. After all she said “Wall Street convinced investors that they were just as good as cold, hard cash.” Individuals people and Individual Corporations committed this fraud and individuals should be held accountable, not “Wall Street”.

In closing, companies and individuals on Wall Street will continue to convince their clients to do things against their own interests so long as it is rewarded handsomely for that behavior. And the ethical and honest will continue to leave Wall Street. Investors must insist that individuals like Broker B and Investment Banker B are held to account in civil, if not criminal, court.

A)Huffington Post 2/27/2008 : US Imprisoning More Than 1 In 100 Americans

“For the first time in U.S. history, more than one of every 100 adults is in jail or prison, according to a new report documenting America’s rank as the world’s No. 1 incarcerator.

B) Leonard Lopate Show 2/28/2008 : Unfair Crack and Cocaine Sentencing Guidelines

“According to current federal sentencing guidelines, convictions for the sale of 500 grams of powder cocaine – and only 5 grams of crack cocaine – both result in a 5-year mandatory minimum sentence. Jesselyn McCurdy, legislative counsel for the ACLU, explains why this sentencing disparity is unfair and fails to address the larger problem of the drug trade. Karen Garrison is the mother of 2 sons who are each serving long sentences in federal prison for non-violent crack cocaine offenses.”

C) Bloomberg 12/13/2008 : Bush Fraud Probes Jail Corporate Criminals Less Than Two Years

“Median sentences for white-collar crime changed little in the 1990s, holding in a range of 12 to 13 months, commission data shows. That number increased to 15 months in 2001 and reached 18 months last year, reflecting the new guidelines…On July 17, the task force’s five-year anniversary, then- Attorney General Alberto Gonzales announced that the department had obtained 1,236 corporate fraud convictions….”

I’ll leave it to someone else to crunch the numbers thrown out in all these stories. It should be obvious that with 1,236 corporate convictions of less then two years, on average, would account for less the 0.0001 percent of the current prison population.

Even the high profile convictions of Enron, Ebbers and Conrad Black do not change the profitability of corporate crime.

From Bloomberg: “Sixteen HealthSouth employees pleaded guilty and helped prosecutors unravel a $2.7 billion accounting fraud that surfaced in 2003. Eleven got no time in prison. Former HealthSouth CEO Richard Scrushy was acquitted of accounting fraud charges.”

Ask yourself what the punishment might have been for these sixteen individuals if they were caught selling $2.7 billion of crack or even 2.7 pounds.

Unlike drug use or dealing, corporate fraud is not a victimless crime, so why the lighter sentences??

From Bloomberg: “SEC Struggles to Pin Insider Trading on Fund Sales“ Simply put, Hedge funds that make money on inside information and inside access to private stock offerings escape prosecution. Just another example of eroding trust in the financial markets.