Auction Rate Securities Hit The Headlines Again

Last April I wrote this post, the third in a short series at the time when auction rate securities were becoming a hot topic in the financial sector.

Only last month, I wrote this one, about UBS's new CEO, mentioning the ARS mess he had to handle.

As reported in the Wall Street Journal this morning, UBS, as well as Merrill and Citigroup have caved in to New York Attorney General Andrew Cuomo and promised to buy back billions of dollars of these improperly marketed securities.

According to the article, Merrill will repurchase some $10B of the ARSs, while Citi pledged to buy back about $7B, and assist its clients with selling another $12B of the toxic instruments.

Breaking stories this afternoon on the internet have UBS agreeing to repurchase some $8.3B of the ARS instruments they bamboozled their clients into stuffing into their portfolios.

Some fines are being levied, too. And well they should be.

When you consider the wider context of the CDO, sub-prime mortgages and ARS debacles, a pretty clear pattern of financial sector malfeasance and general disregard for customer and investor welfare emerges.

As I was contemplating this post earlier today over lunch, I realized that a story from way back in my career at Chase Manhattan Bank, in the late 1980s, is highly relevant. I may have written about it before, but it bears repeating in this instance.

As part of a mortgage banking project, I attended a CMO conference featuring the hot sector speakers/leaders of the day- Lewis Ranieri, Dexter Senft, Larry Fink, and other notables from Salomon Brothers, First Boston and Morgan Stanley.

Most of the audience was composed of S&L and small commercial bank executives eager to offload their mortgage portfolios and reduce interest-rate mismatch risk in the RTC environment.

As I sat with a random group of these financial industry worthies for the rubber-chicken lunch, we began to discuss the morning's presentations.

When I asked the banker to my left if he found the conference useful, he said that he did. Further, that he used these same bankers to package up and sell his mortgages, because it was sure difficult to properly value them for sale.

In answer to my question, he said something like,

'Yes, I need Salomon to help me, because I wouldn't know what the right value of these securities should be, with all the complex modeling.'

Then I asked him if his bank also bought CMOs from Salomon and their ilk. He replied, "yes."

Which led to my next question of him,

'But, if you need Salomon to tell you what the value of these complex securities for sale, how do you know that the price at which they offer similar CMOs to your bank to buy is appropriate- without such a banker doing the complex math to evaluate the price?'

In answer to my obviously embarrassing question, the banker promptly turned to his right and proceeded to converse with that person for the remainder of lunch.

You see my point?

Buyers of financial service products, especially 'structured' products, should know the intrinsic value and risks of such products on their own. They should not simply trust an institutional salesperson to tell the the truth- the whole truth.

Buyers of ARSs were defrauded- this is clear. They were lied to regarding how liquid the instruments would be, and that the added yield over money market instruments was somehow riskless.

But, really, in the end, should they not have known enough to ask questions? Like,

"But, how can they have a higher yield with no added risk? Surely, there must be something about them that is riskier? What is it?"

When you read about retail customers losing millions of dollars in these ARS investments, don't you wonder how they could be sufficiently intelligent to amass that much money, only to be so easily hoodwinked by some financial schlockmeister spinning tales to separate them from their hard-earned money?

The moral of my story with the mortgage bankers from the 1980s applies to the ARS market as well.

You should never purchase financial assets whose behavioral/valuation characteristics you do not completely comprehend. And if the reason you don't comprehend them is that they are 'too new,' then immediately run- don't walk- the other way.

You are likely to be fleeced.

Today, three large financial institutions agreed to repurchase some $25B of fraudulently marketed ARS investments. That's a lot of damage to retail investors.

And, of course, the next shoe to drop is where the already-capital-strapped banks will find the $25B in capital to pay for this settlement of the ARS issue.

Could this be the last straw for John Thain's Merrill Lynch, or Pandit's Citigroup?

Time will tell. But it looks like yet another ill-considered, rapacious financial services gambit has come home to roost with its purveyors.

Another reason to steer clear of financial service equities for some time to come.