On Auction Rate Securities & Brokerages

I have written five pieces on the subject of auction rate securities, the latest one found here, less than a month ago. In it, I related the humorous and shocking revelation by James Stewart, a financial advice columnist for the Wall Street Journal, that he, too, was a victim of these instruments. In my post, I wrote,

"Which brings me to a hilarious companion piece in the same WSJ edition.

It seems that James B. Stewart, a regular investment columnist who writes "Common Sense," lost his. He spent yesterday's column bitching about his lack of satisfaction as a 'victim' of the ARS mess.

Stewart alleges,

"It's not like we were clamoring to buy these securities. Like other victims I've heard from, I got a call urging me to take advantage of an offer that was being extended to valuable clients."

For more on this, see my prior, linked post, for my story of the early days of CMOs and their buyers.

But, back to Mr. Stewart. For someone so lofty as to write a column in the WSJ on investing, wouldn't you think he would know better than to offer an excuse like the above for purchasing ARS notes? Really- something for nothing, James?

Free extra returns, just for 'valuable clients?'

I have to laugh, because I've never bought any structured finance instrument in my life. The market-making assurances on these instruments are simply not to be believed.
Anyone with any experience in securities markets would know this."

Now, in an article from the weekend edition of the WSJ, we learn just how misguided and gullible Stewart really was for believing the 'valued customer' hokum.

Here are some of the choicer passages from the Journal's recent piece,

"For years, financial advisers promoted auction-rate securities to clients, friends and even family. Now, in the latest twist of the roiled credit markets, some brokers are siding with customers who allege that the securities weren't as billed. They were widely pitched as higher-yielding alternatives to easily bought-and-sold, super-safe money-market mutual funds -- but investors like Mr. Pellizzetti have been trapped in them since February, unable to cash out at full value after the market for auction-rate securities collapsed.

The auction-market crisis appears to be slowly working itself out. In recent weeks, most of Wall Street's biggest brokerage firms, including UBS, have agreed to buy back more than $40 billion of auction-rate securities from their clients, including individuals, charities and small businesses. Some have reached pacts with state and federal authorities to resolve probes into their sales, while other investigations continue. The pacts may help investors like Mr. Pellizzetti get their money back.

In the wake of all this, a behind-the-scenes debate is unfolding about the role played by brokers. Even as the auction market burgeoned to $330 billion in recent years, many brokers knew little about its inner workings, according to regulatory documents, lawsuits and interviews with brokers and their clients. Does that make financial advisers victims, too, if they reasonably relied on their firms' descriptions of the products, however thin they were? Or are securities brokers obligated to learn as much as they can about any investment they pitch, ensuring they themselves fully understand what they are selling?

Tamar Frankel, a professor at Boston University School of Law, says brokers' legal liability is a bit of a gray area, but her opinion is that a broker is obligated to learn about what he sells. "If he sells poison, he's got to know."

In interviews conducted by Massachusetts regulators and included in the state's complaint against UBS, a UBS financial adviser, Leonard Burd, acknowledged receiving no training on the securities other than marketing materials posted on UBS's intranet, and said he didn't read those materials or know of any risks before UBS pulled out of the market in February.

"All I knew" was that the auctions "worked in my career for 10 years seamlessly, and I had no understanding as to the backdrops of it at all," said Mr. Burd in the interview. Reached by phone, he said attorneys didn't want him to speak to the media.

"According to Mr. Pellizzetti's son, internal UBS sales meetings described any chance of auction failure as 'remote & temporary' explaining that at worst any illiquidity would be resolved" in the very next auction for that security, the claim alleges. After his son left UBS, Mr. Pellizzetti continued to purchase the securities through another UBS broker, the claim says.

One factor in financial advisers' willingness to promote the securities may have been the richer commissions they brought. At UBS, for instance, financial advisers received a portion of the 0.25% reward received by their firms for managing the securities, while no commission was available for putting the same investors in UBS's standard money-market fund, according to the Massachusetts complaint.

UBS denies that its advisers had an incentive to put clients into auction-rate securities.
Some brokers apparently did dig deeply enough to figure out that the securities were problematic. The Massachusetts complaint against UBS cites Jan. 10 emails from Sarah M. Sullivan, a financial adviser in Boston, to a senior manager explaining her reluctance to pitch the securities to clients who wanted alternatives to low-yielding money-market funds.

She had just listened to a conference call by UBS auction-market specialists aimed at boosting sales of the securities, according to the complaint. "We continue to be frustrated by the lack of information that they are providing to us," she wrote. She said she would be particularly concerned about putting any client into the securities just ahead of the April 15 tax-filing deadline. "If there is a failed auction, the client may not be able to access the funds. The bottom line is that rather than moving more cash into [the securities] we will probably be liquidating them for many clients."

She concluded: "Given the strange and difficult environment, it is imperative that we are fully aware of the risk we are taking. We do not want to imperil any relationships over something as 'simple' as their cash investments."

A follow-up email from the senior manager instructed a colleague to "get one of your people on the phone with Sarah ASAP so we can provide the appropriate color." The complaint doesn't detail Ms. Sullivan's subsequent actions. A spokesman for Mr. Galvin, the Massachusetts' regulator, said the state wouldn't comment beyond what is in the filings. UBS declined to elaborate or make Ms. Sullivan available for an interview."

My reason for presenting these extended passages is to refute some truths implied by the WSJ's financial columnist, James B. Stewart.

To wit, I contend that, in reality, you should believe that your broker is NOT:

a) well-informed and educated about what s/he is peddling to you.
b) truly interested in your economic welfare first, before their own.
c) unmotivated by commissions on what they sell you.

When you hear the phrase 'valued client' from a broker, run, do not walk, the other way. Hang up the phone, close and delete the email.

From the Journal's extensive article on the UBS case involving auction rate securities, we see that many brokers simply have no idea of the nature and behavior of many financial instruments which they sell to clients, once those instruments go beyond basic equities, debt and simple money market accounts.

Investor beware.