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Monthly Archives: June 2008

UBS Fails to Disclose Risk of Auction-Rate Securities to its Investors

In a lawsuit filed yesterday by Massachusetts Secretary of State William Galvin, the head of UBS AG’s municipal securities group David Shulman is alleged to have exchanged emails with UBS executives that discussed how the bank should promote its failing auction-rate bonds as money market securities.  UBS attempted to shift its burden of $11 billion in auction-rate bonds by selling them to investors.

The emails also indicate that UBS almost pulled out completely from the auction rate market nine months ago, but instead bought out bonds in order to prevent the auctions it managed from failing. These emails came after the fact that UBS executives recognized the high risk of auction-rate securities in August. Despite these warning signs, the emails indicated that UBS faced pressure to free up capital because it had an overload ($10 billion) of auction-rate holdings. 

Galvin holds UBS responsible for committing fraud for not informing investors that the auction-rate market was collapsing. Galvin also plans to have UBS liquidate its auction-rate bonds, which adds up to $190 million, so investors can get their money back.   

Last year, the popularity of auction-rate bonds decreased significantly for securities firms (who are typically the buyers) in the auction-rate market because the bonds were reclassified as long-term investments rather than money-market instruments. Many investors are now left with bonds that will not sell and are having to pay high penalty rates. 

Auction-Rate Securities: Who Knew What and When?

Investors harmed by the current auction-rate market meltdown accuse Wall Street of hiding the recognized risks of the securities from them. According to a June 26, Bloomberg article, some investors are even comparing this crisis to the dot-com scandal involving former Merrill Lynch analyst Henry Blodget.

Many wonder why brokers did not see the impending catastrophe for the market. But, according to recent reports they actually were aware.   

To date, at least 24 proposed class action lawsuits have been filed against brokerages. A nine-state task force is also investigating how these firms went about marketing the securities to clients. Among the task force is Massachusetts, which charged UBS Thursday with fraud for its sale of auction-rate securities to investors in the state. They claim UBS told clients their investments were “safe, liquid cash equivalents”, when they had knowledge this was completely not the case.  

One investor claims her broker at UBS recommended investing in auction-rate securities last December. At the same time UBS is reported to having told an issuer of these securities that the $330 billion market was in danger of collapsing. Shortly thereafter, dealers who underwrote and managed the market for over 20 years were forced to stop buying as last resorts due to the escalating mortgage losses in February.  

Over the past two decades, auction-rate bonds have allowed local governments, hospitals and universities to borrow money for the long term at cheap, short-term rates because they would resell the debt at upcoming auctions every seven, 28 or 35 days.  Once banks were no longer the “last minute buyers”, rates skyrocketed as high as 20 percent because failed auctions brought a penalty rate for issuers. In many cases, this penalty rate was set recently due to banks recognizing a decrease in demand. 

As light continues to shine on the problems associated with the auction-rate collapse, it becomes clearer every day that some on Wall Street were well aware of the potential issues with these products before the auctions themselves started to fail.    

Some Closed-End Fund Companies Refuse to Redeem ARS Preferred Holders

Over the past few weeks, some of the largest closed-end fund companies, including Eaton Vance Corp. and Nuveen Investments Inc., have disclosed plans to redeem their auction-rate preferred securities. This solution may allow some irritated investors to cash out quickly.   

However, many other closed-end fund companies have yet to announce plans to redeem their auction-rate preferred securities.  The reason given is to protect their common shareholders.  

Companies are worried cashing out preferreds right now will hurt their common shareholders. Therefore, the preferred holders may have to wait months or even years before they are able to cash in.   

Prominent closed-end operations that have not publicized a redemption plan include; Allianz SE’s Pimco and Nicholas-Applegate funds, Lehman Brothers Holdings Inc.’s Neuberger Berman funds, Bank of New York Mellon Corp.’s Dreyfus funds, and Pioneer Investments. Together they have totaled $7.6 billion of auction-rate preferred. 

Auction-rate preferreds are long-term securities that functioned like short-term investments. But, when the market stopped functioning like normal, buyers for these securities vanished in auctions. Holders have been stuck in a slump by fund companies since the credit crunch weakened in February.

Ed Dowling owns preferreds issued by five different companies, including $300,000 in Neuberger Berman, which is the only one yet to redeem any his securities. He is questioning the future of his funds and is even considering selling on the secondary market at a loss.   

The problem fund managers are struggling with is whether replacing the auction-rate debt with other leverage would be more expensive and would consume fund earnings. Action-rate financing has the benefit of longer maturities than bank loans and bonds typically have. Funds that replaced the preferreds with bank borrowings run a risk that the bank may charge a higher rate to extend the loan, or not extended it at all. 

According to the Wall Street Journal, when the market started declining there were about $64 billion of these securities issued by closed-end funds. Now, just 31 percent has been redeemed, or plan to be shortly.

Who Should Police Wall Street

Securities and Exchange Commission (SEC) Chief Christopher Cox is facing criticism for his lack of involvement in handling Bear Stearns’ financial crisis. The failure of Bear Stearns and alleged neglect from Cox has stimulated debate over who should be in charge of Wall Street, the SEC or the Fed.

Treasury secretary Henry Paulson suggested broadening the Fed’s responsibilities to include overseeing investment banks. 

Bear Stearns began having problems last July when two large hedge funds collapsed due to securities tied to subprime mortgages. The firm incurred $1 billion in write-downs by December. Some critics argue that Cox and the SEC should have pressured Bear Stearns to raise capital and increase the confidence in their investors.  

Cox was said to have been absent during crucial conferences with the Fed and the Treasury, who negotiated a bailout plan for Bear Stearns. One such call discussed J.P. Morgan Chase & Co. granting a loan to Bear Stearns, and the other meeting discussed J.P. Morgan potentially buying out Bear Stearns and the Fed’s role in lending money to investment banks.  

Many of Cox’s predecessors, such as Richard Breeden and Harvey Pitt, were seen as more proactive in taking charge over the securities market during times of financial turmoil.

According to reports, Mr. Cox claimed that the SEC acted appropriately during the Treasury and Fed bailout negotiations because the SEC’s responsibility was to regulate the industry—not arrange its deals.

Cox has encouraged constructive debate over the issue of shifting authority to the Fed, but his stance is primarily passive, saying that the outcome is up to lawmakers in Congress and not the SEC. He also says that if the Fed continues to loan money to investment banks, it will inevitably play a larger role in Wall Street.

Evergreen Investments Liquidates $403 Million in Mortgage-Backed Securities

According to reports, Wachovia’s money-management unit, Evergreen Investments, will be liquidating $403 million from its Ultra-Short Opportunities Fund. The fund, which is primarily backed by mortgage securities, has lost 20% this year alone and has dropped 18% just this month.  

The failure of this fund highlights the ongoing problem brokerage firms are having in pricing the value of their investors’ illiquid investments. Bond-fund managers are being pressed to ensure their holdings are valued correctly so investors receive the correct amount of liquid funds from their shares.  

As of March, two thirds of Ultra-Short Opportunities assets consisted of home-loan securities that were not backed by government entities. The fund also carried only 70% ($9.1 million) of the original value of Novastar ABS CDO I Ltd. because it was created from low-rated subprime-mortgage bonds.  

Wachovia wrote down the value of its bank-owned insurance policies this spring, which resulted in a loss of $708 million on May 6th. The bank also paid a $144 million settlement over complaints of telemarketers and payment processors stealing from customer accounts under the supervision of former Chief Executive Kennedy Thompson.  

Although debt-pricing companies such as Interactive Data Corp. and Street Software Technology, Inc. are making strong efforts to place correct valuations on securities, difficulties arise in getting an accurate price when high-yield or non-investment-grade bonds aren’t trading in high volumes.  

Other firms such as Charles Schwab and Fidelity Investments are facing lawsuits from investors who have suffered substantial losses due to the sub-prime mortgage crisis.

Investors Question the Value of Their Investments

Investors who put their money in two Bear Stearns hedge funds last spring are finding themselves uncertain, to say the least, about the value of these deteriorating funds. Former Bear Stearns’ hedge fund managers, Ralph R. Cioffi and Matthew M. Tannin, were charged this week with nine counts of securities, mail, and wire fraud.  

This case highlights the problems Wall Street is facing regarding how to value investments that have suffered from the subprime mortgage crisis. For example, Cioffi substantially undervalued one of the hedge funds, saying its loss was 6.5% in April, while colleagues at Bear Stearns said the loss was three times higher than what Cioffi valued.  

On a worldwide scale, banks and bank executives are writing down the value of their assets by as much as $380 billion. This year, Credit Suisse, Merrill Lynch, Morgan Stanley, and Lehman have had employees caught for overpricing the value of various assets, costing the firms and investors millions of dollars. 

Although executives are increasing their supervision over employees to prevent future dishonesty or over-optimism about valuations, the pricing process has become the bigger controversy. For example, rather than using only market prices, the chief financial officer of Citigroup said the company would use collateralized debt obligations as another determinant in pricing. Other investors have complained that Wachovia and Washington Mutual are using an over-optimistic housing index when modeling values.  

Write-downs occur usually when banks are selling in the market; although, banks such as Bank of America have refused to mark down the C.D.O.’s of a city in the Southeast because they did not want to be forced to mark down their other holdings, or cause a domino effect. 

Some steps have been suggested to remedy these problems, like expanding the evaluation period of traders to possibly prevent future valuation misconduct.  But the question for many investors remains: what are my investments worth?

Bear Stearns’ Hedge Fund Mangers Arrested

Matthew Tannin and Ralph Cioffi, former Bear Stearns’ hedge fund managers, were taken into custody at their homes Thursday morning. They are facing criminal charges due to the collapse of the subprime mortgage market and the resulting implosion of the two hedge funds they managed.  

Both former executives are accused of deceiving investors about the risk of their investments in subprime mortgages. The principal question is what did they really know when they presented the funds as promising investments.  

The prosecutors look to rely heavily on private emails.  According to the Wall Street Journal, the two allegedly sent emails implying the funds they invested in were about to crash four days before they told their investors they were confident in these funds. Tannin supposedly told Cioffi he thought the market they invested in was “toast” and wanted to shut down the funds.  

“The arrests are appropriate given the magnitude and the egregiousness of their alleged misconduct,” said attorney Steven Caruso, who is representing investors in arbitration cases against these funds.  

Their arrests are the first of possible fraud cases by banks and mortgage firms whose investments in the subprime market decreased in value. The market’s losses are now totaling around $396.6 billion. The current indictments may lead to several other criminal cases and civil suits in the future. 

Bear Stearns’ termination should have been predicted when the Federal Reserve intervened early this year to bail out the bank after the hedge funds collapsed. This collapse added fuel to the fire for the recent credit crisis. It was proof that the market could critically impair the companies that bought and resold these loans.  

Tannin and Cioffi were brought up in lawsuits last year by hedge fund investor, Barclays Bank, claiming they were purposely misled. Barclays stated Bear Stearns’ knew for months the assets in its Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund had decreased in cost since their original value.  Barclays reported that the email from Tannin said the fund is “having our best month ever.” But, at the time the fund was actually having “severe liquidity problems, and lost hundreds of millions of dollars.”  The funds failed despite Cioffi and Tannin’s positive evaluations , resulting in over $20 billion in assets to crash.

Bear Stearns’ Hedge Fund Managers May Face Charges of Securities Fraud

Former Bear Stearns Cos. managers Ralph Cioffi and Matthew Tannin are on the verge of criminal charges for securities fraud for mismanaging two Bear Stearns Cos. hedge funds, costing investors $1.6 billion in losses.  

Federal prosecutors have suggested that Cioffi and Tannin could face indictment. “At issue is whether the managers intentionally misled investors by presenting a rosy picture of the funds at a time when they were privately communicating with colleagues about their worries over how the investment vehicles would ride out weakness in the mortgage market,” says Wall Street Journal reporter Kate Kelly.  

Bear Stearns’ recent history of financial problems has raised concerns over its management abilities and risk controls. Bear Stearns invested large amounts of borrowed securities into bonds backed by subprime mortgages.

Despite the subsequent meltdown of mortgage-backed securities, Cioffi and Tannin remained optimistic about the subprime market. However, in May 2007, Bear Stearns was unable to repay its investors with cash and meet demands from lenders for additional cash, or margin calls. As a result, Bear Stearns lent $3.2 billion in order to recover its High-Grade fund only to see the funds file for bankruptcy protection a month later. Additional losses to the firm came from the bond market losses and investor panic. 

The potential indictment of managers from Bear Stearns, now part of J.P. Morgan Chase & Co., could mark the beginning of more investigations dealing with the mortgage-market crisis, which began a year ago. More financial firms are taking precautions to provide more precise valuations on their holdings of mortgage securities.

Options for Holders of Auction Rate Securities

In the four months since auction-rate securities collapse, many investors are left with nothing else to do, but take out loans, sell their securities at discounts, file arbitration cases against brokers, or wait and hope the market returns to normal.  

One of the many investors affected by the current market was advised by her broker to invest her entire $375,000 divorce settlement into auction-rate securities last December. She was planning on using this money for her daily needs, but has yet to see a dime since the market froze up.  

Her brokerage, UBS AG, offered a margin loan backed by her account to get by with day-to-day expenses. But, later UBS marked down the value of the securities and demanded she repay part of the loan. She received her second margin call requesting money last week after UBS marked down her securities again by about 50%.  Unfortunately, this is not uncommon.    

An investor with A.G. Edwards fell into a similar situation last September when she came into $1.25 million from the sale of a business. She planned on using the funds for a tax payment. Her broker also advised she stash her money into auction-rate securities issued by mutual-fund companies.  She eventually had to take out a home-equity line of credit to pay taxes.  She left A.G. Edwards and moved to a new firm. The new firm advised her to sell the securities (for a loss) on a secondary market- the Restricted Stock Trading Network.  

Brokers recommended auction-rate securities to investors who wanted a safe, liquid investment. Individuals and companies purchased auction-rate debt from municipalities, charities, student lenders and closed-end mutual funds for years because of the pitch as a safe investment with a higher yield than a money market fund. 

In February, it became almost impossible to find bidders for these auctions as the subprime crisis extended to nearly all areas of the credit market. Wall Street firms refused to support the $330 billion market as well, causing it to freeze up and leave many investors out of luck. 

The student-loan backed security, an $80 billion portion of the auction-rate market, was hit predominantly hard because the interest rates reset to such low levels, in some cases 0%. The interest rates on auction-rate securities issued by mutual finds or municipalities have been much stronger, because when the auction fails the rates automatically reset above a benchmark rate.   

According to the Financial Industry Regulatory Authority, the securities industry’s nongovernmental regulator, about 80 arbitration claims dealing with auction-rate securities have already been filed.  More are coming.

More Disclosures for Bond-Rating Firms

The Securities and Exchange Commission is expected to propose today new requirements that will require bond-rating firms to disclose more information to the public. But will that be enough to restore confidence in the $5 billion-a-year industry?  

SEC officials found the old models used by the rating firms for complex structured products were underdeveloped. A majority of the new proposals will hold the firms more accountable and encourage them to change their practices. This proposal is the first step the SEC is taking against claims that bond-rating firms were ranking mortgage-related securities higher than necessary. 

The SEC is expected to mandate companies disclose historical ratings performance, including the dates of downgrades and upgrades. Rating firms, like Moody’s Corp., Standard & Poor’s and Fitch, will be required to publicize information used to determine ratings, the amount of research they acquired and how often they check the effectiveness of the ratings.  

The SEC will also suggest a new ratings scale to clear up confusion between complex structured debt from corporate debt. It will most likely propose rating firms identify the difference by using a notation “v” (for volatility), or explain how the methodology and risk of that bond differ from a similarly rated corporate bond.  

The hope is the new analysis and suggested rating system will give investors a better understanding of the accuracy of the rating.  

The SEC also hopes to demolish conflicts of interests in the proposal. According to The Wall Street Journal online, these issues range from bond issuers’ ability to influence which analysts are chosen to rate a particular bond, to expensive dinners, and to analysts being permitted to rate deals they helped structure. Analysts will also receive new boundaries dealing any type of bribes with the bond issuers or their bankers.  

This proposal comes just a week after the three largest rating companies settled with New York Attorney General Andrew Cuomo on how the firms collect fees in order to not rely on winning bond issuers business.


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