In the News: Recent Developments

December 12, 2008

Auction-Rate Fees “Intoxicated’ Dealers, UBS Said

By Michael McDonald

Fees from selling auction-rate securities “intoxicated” Wall Street bankers before the $330 billion market collapsed this year, a UBS AG executive wrote in an e-mail released by the U.S. Securities and Exchange Commission yesterday. “The fools in this trade are the dealers that perpetuate the structure because they are intoxicated by the fees,” the head of UBS’s municipal securities group, who wasn’t identified in the document, wrote in December.

The e-mails were disclosed by the SEC after it completed settlements with Zurich-based UBS and Citigroup Inc. in New York requiring the firms, which were the largest underwriters of the debt, to redeem about $30 billion of the securities. About 20 firms in all have agreed to buy back more than $50 billion of the bonds since the first preliminary settlement was unveiled in August. The SEC accords require a judge’s approval. The companies didn’t admit or deny wrongdoing in settling. The market unraveled when banks that supported auctions of the securities for two decades with their own money as buyers of last resort suddenly pulled back to preserve capital amid the mortgage market collapse that led to $987 billion of credit losses and writedowns worldwide. UBS brokers “lived off this business for a decade,” before the market imploded in February, one senior manager at the firm said in an e-mail cited by the regulator. Banks produced “substantial” revenue underwriting the securities and running periodic auctions that set interest rates, the SEC said in settlements with UBS and Citigroup.

UBS Trader

David Shulman led UBS’s municipal securities group at that time, leaving the firm in August after regulators began probing its auction-rate sales. Kris Kagel, a UBS spokesman, declined to comment on the identities of executives in the report. Shulman didn’t return calls seeking comment. Robert Anello, an attorney for Shulman, declined to comment. States, student-loan agencies and closed-end mutual funds were the primary issuers of the securities, long-term bonds with interest rates set at weekly or monthly auctions. The debt, marketed by bankers as cash equivalents, offered investors yields of a quarter-percentage point or more above conventional money-market funds, indexes show.

Thousands Failed

Thousands of auctions failed, leaving buyers stuck with securities they couldn’t sell, while borrowers paid so-called penalty interest rates as high as 20 percent. Issuers refinanced or offered to buy back at least $142 billion of the securities, according to data compiled by Bloomberg News. When the market flourished, borrowers paid dealers on average quarter-percentage point a year of the par value of the debt to run the auctions, generating about $825 million annually based on the amount of sales. Citigroup increased the commission its financial advisers earned selling the bonds to investors as the market stalled. “Just make sure all hands are on deck and paper is sold,” an unidentified Citigroup official wrote in an e-mail cited by the SEC in a complaint where it accused the bank of misrepresenting the risks of buying the debt. “Times like these, we need to do whatever is necessary.” Investment banks also earned more than $1 billion over two decades underwriting the auction-rate market, based on average fees paid for the services. Most states and local governments entered into interest-rate swaps after selling the securities, generating additional fees for the banks, Joseph Fichera, chief executive of New York-based Saber Partners LLC, said at a public finance conference in October.

“Flawed Product”

In those swaps, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index. Public agencies pared the swaps with the auction-rate debt to create pseudo fixed-rate obligations. Auction-rate securities were a “flawed product,” because ultimately the banks had to step in as buyer of last resort as demand crumbled last year, one UBS executive complained in an e- mail cited by the SEC. Many institutional investors stopped buying the bonds after accounting rules changed and the obligations were no longer viewed as short-term holdings. “The program had gotten too big,” a UBS employee who sold securities to investors wrote in an e-mail after auctions began failing last August. UBS considered and later abandoned refinancing $26 billion in student loan auction-rate debt it sold and replacing it with more conventional variable-rate securities, according to the SEC complaint.

Underwriting Ended

Citigroup investment bankers wanted to keep selling new auction-rate securities even as demand tumbled last year in order to earn keep earning the fees and maintain their top underwriting spot, according to the SEC complaint. The firm didn’t curtail new issuance until November, the SEC said. UBS, which closed its municipal underwriting operations in May, said after its preliminary deal with regulators was announced in August that the settlement provides relief to all its clients, including individuals, companies and institutions. The agreements between the SEC and UBS and Citigroup were the largest in the history of the agency, Christopher Cox, the chairman of the regulator, said yesterday. UBS also agreed to pay fines of $150 million in August and Citigroup agreed to a $100 million penalty. “Today is an important procedural step in the ongoing process of resolving this matter,”Citigroup spokesman Alexander Samuelson said in a statement yesterday. “We have already purchased substantial amounts of auction-rate securities from our clients.“

–With reporting by Karen Freifeld and David Scheer in New York and Darrell Preston in Dallas. Editors: Michael Weiss, Robert Burgess

To contact the reporter on this story: Michael McDonald in Boston at +1-617-210-4639 or
To contact the editor responsible for this story: Michael Weiss at +1-212-617-3762 or

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