- The Washington Times - Tuesday, August 12, 2008

NEW YORK | Wall Street’s costs to end federal and state investigations of the auction-rate bond market’s collapse may wind up exceeding the sanctions from abuses of mutual funds and analyst research in the past decade.

UBS AG and Citigroup Inc. agreed last week to buy about $26 billion of auction-rate bonds from clients and pay $250 million in fines after regulators said the firms marketed the securities as safe alternatives to money-market investments. Merrill Lynch & Co. announced a plan to purchase $10 billion of the securities, and investigations of other firms that sold the debt continue, New York Attorney General Andrew M. Cuomo said Friday.

The fallout may entail more than penalties as banks are forced to write down the value of the debt they purchase. Those write-downs alone may reach $4 billion, Bank of America Corp. analyst Jeffrey Rosenberg estimated last week, more than three times the $1.4 billion that Mr. Cuomo’s predecessor and other regulators won from 10 firms accused of using tainted research to win investment-banking deals. The 2003 probe of mutual-fund abuses yielded more than $5 billion in penalties and agreements to reduce fees.

“These are developments of gigantic, historic proportions,” James Cox, a securities law professor at Duke University in Durham, N.C., said of the auction-rate agreements. “Never have we witnessed defendants, who created a product that isn’t inherently illegal, being required to buy back such a large market.”

The auction-rate settlements come six months after the $330 billion market seized up as investors fled all but the safest government bonds. Auction-rate debt had allowed municipalities, student loan companies and mutual funds to raise long-term money with short-term yields because interest rates were set every seven, 28 or 35 days through auctions run by dealers including UBS and Citigroup. But those dealers, saddled with growing losses on debt tied to subprime mortgages, stopped buying the securities that bondholders didn’t want.

UBS, Citigroup and Merrill may purchase securities that have already lost as much as 30 percent of their value, according to prices posted on online platforms run by New York-based Restricted Stock Partners.

Bonds sold by local governments, hospitals and colleges trade at 92 to 98 cents on the dollar, said Barry Silbert, chief executive officer of Restricted Stock. Auction-rate preferred shares issued by mutual funds are at 85 to 92 cents, he said. Debt backed by student loans is valued at 70 to 85 cents.

UBS, Citigroup and Merrill were among the largest underwriters of auction-rate debt, according to Thomson Reuters. The other biggest banks in the market include New York-based Morgan Stanley, Goldman Sachs Group Inc., JPMorgan Chase & Co., and Lehman Brothers Holdings Inc., Royal Bank of Canada in Toronto, and Wachovia Corp. and Bank of America, both in Charlotte, N.C.

Mr. Cuomo and other state attorneys general are continuing to examine the market.

“We’re looking at the entire industry,” Mr. Cuomo said at Friday’s press conference to announce the settlement with UBS.

Securities firms may avoid additional fines if they use “best efforts” to help their clients get out of the securities, the U.S. Securities and Exchange Commission said last week when the settlements were announced.

Banks will need to find ways to dispose of the auction-rate securities to recoup their money.

“If the banks themselves are taking them back onto their balance sheets, they’re not going to be slow to offload that liability,” said James Colby, senior municipal strategist at money-management firm Van Eck Associates in New York. “Sooner rather than later, the issuers that stand behind” the debt “are going to be encouraged by the banks to find a way to close the books on these products,” he said.

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