So, you've probably heard sometime during the past week or so that major Wall Street Firms have been cooperating with state and federal regulators to give some sort of restitution to their retail customers who purchased auction rate bonds this year.  These bonds, which have nominally long terms, were bought with the sense that they could be resold at auctions within a week or a month.  Therefore, customers who wanted the liquidity of a money market account or a short-term CD were attracted to these investments, which had a higher rate of interest than those risk-free investments.  However, beginning in Februrary 2008, no bidders showed up at these auctions and the customers were left with, gee, long-term bonds.  The customers were faced with either leaving their money tied up indefinitely or selling at a deep discount.

But now, UBS AG, Citigroup, Merrill Lynch, and most recently, Morgan Stanley and J.P. Morgan have agreed to buy back these securities from their retail investors, for a total of over $40 billion.  (Morgan Stanley and J.P. Morgan will also pay civil penalty fines.)  And, the banks will compensate customers who sold at a loss since February as well.  (Let's leave aside for the moment why this settlement is just for retail investors.)  These capitulations have come as Andrew Cuomo, attorney general of New York, attorney generals of other states, and in some cases, the SEC have begun investigations, issued subpoenas, and in some cases, made charges of fraud.

OK, so what happened?  We know that brokers generally don't give people their money back when they have losses, even when those losses are the result of investments that may have been too risky.  These can't be general suitability claims, where the risk of liability at the hands of arbitration is very low.  Something seems to have been going on besides spicing up portfolios with a little too much risk.  According to some accounts, these investments were marketed as cash equivalents, with the same liquidity risk as a money market account, and some investors' monthly statements have these investments listed as "cash."  How could that be?  Brokerage houses generally aren't going to mischaracterize something on a statement that is obviously false.

Well, here's the rub.  For 20 years, auction rate bonds functioned pretty much as cash equivalents, with better rates of return than cash equivalents.  During that time, no bidders showed up at these weekly auctions only 44 times.  So, historically, these securities had very little liquidity risk.  However, this was because the investment banks often served as bidders when there were none.  For their issuer clients and their investor clients, a small group of auction rate banks, including Citigroup, UBS, Morgan Stanley and Merrill Lynch, smoothed out market mismatches and basically created the market by being the buyer on occasion.  But, for various reasons, the market started to get fairly bloated and buyers became rarer.  The banks were providing the liquidity more and more during the past 12 months, until in February 2003, they stopped.  The banks had too many auction-rate bonds in their portfolios and just couldn't do it any more, meaning that their customers were stuck.

Lamentable, but legally what is the problem?  The banks weren't legally obligated to buy these bonds -- the customers did not have a "put" option from the issuer or the broker.  Well, the problem could be that during the time banks were slowly coming to realize that these securities were not low-risk liquid investments, they continued to market them to their customers.  A worse scenario is that they aggressively and fraudulently marketed them to their customers to get them off their own books.  An even worse scenario is that they aggressively and fraudulently marketed them to their retail customers because they needed a new pool of buyers to make the market work again.  In these situations, the banks knew that they weren't liquid and that the music was about to stop on the musical chairs game, and they pushed their retail customers into the game with false promises of liquidity right before they themselves stopped the music.  Oops.  And, there's even been some accusations of false analysts' reports touting auction-rates as a result of pressure from the auction rate desk (at Merrill Lynch).  Hmm, I thought we passed some regulations to stop that. . . .

So, the settlements are aimed at keeping regulators happy by compensating the investors.  But, this makes the high-worth investors who are not being compensated unhappy.  Maybe the banks thought their liability with sophisticated investors was less likely, or maybe they will make them happy in other "relationship" ways.

What should be cheery to everyone is how efficient this solution is (if it makes the investigations and regulators and class-action lawsuits disappear).  The customers are made whole, without the attorney fee discount.  The banks pay out of their own pocket, but get an asset they may in time gain in value.  The banks can absorb the liquidity risk better than the investor, and in essence are just basically providing the same function as they have all along.  And, the banks can use "relationship" pressure to encourage the issuers to refinance the bonds, recouping their investments somewhat.  Much better solution than either a civil class-action lawsuit, and SEC suit with a "restitution fund," or someone going to jail!

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