UBS: Auction-Rates Securities Collapse

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Trouble Brewing: Internal documents suggest UBS may have seen problems

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When the credit crisis struck, the banks started to choke on the securities they once readily consumed. By August 2007, UBS's inventory had swelled to $3 billion, from $1 billion five months earlier, according to the New York suit. The mounting inventory raised red flags among UBS's risk managers. "There is little tolerance for increased inventory firm-wide," one wrote on Aug. 15 to David Shulman, head of the group that ran UBS's auctions. Shulman, who has been placed on leave, according to a person familiar with the situation, could not be reached.

Mobilizing the Troops

With UBS's stockpile growing, Shulman acted quickly to find buyers among the retail clients served by the bank's wealth management division. According to e-mails, he helped organize a conference call with more than 850 brokers on Aug. 22 to promote the product. "We have encouraged our [wealth management] partners to mobilize troops internally…so we can move more product through the system," he wrote that same day to colleagues in the municipal bond and risk groups. "This is our best and most effective way of hedging our exposure."

Only hours earlier, Shulman had moved to cut his personal exposure. E-mails show that UBS's compliance department cleared him to sell $475,000 worth of auction-rate securities from his own account.

Rush to the Exit

The outside pressures increased in October when manufacturer Potash Corp. of Saskatchewan (POT), telecom equipment maker Ciena (CIEN), U.S. Airways Group (LCC), and other companies announced losses on their securities. Auditors, too, began expressing concern about the market, prompting corporate clients at UBS to try to dump their investments. "I have to do a conference call with another client [chief financial officer] who wants to sell all his [auction-rate securities] because his auditor [PricewaterhouseCoopers] is telling him there are problems…and to get out now," a UBS employee told Shulman in an Oct. 31 e-mail. "I expect other clients to call." Shulman forwarded the note to UBS's chief operating officer, saying "this is a huge albatross."

The worries grew. On Dec. 13, five days before First Lutheran made its final, $100,000 investment, UBS staffers sent a flurry of e-mails to their boss, Shulman, warning that "the auction product does not work" and "the entire book [of securities] needs to be restructured out of auctions."

Shulman and others redoubled efforts to sell the investments. In December, he O.K.'d a new deal for auction-rate securities backed by student loans. Shulman also urged several colleagues to "press your relationships within [wealth management] and cash management group harder now more than ever…to do what we need to move this paper as well as current inventory."

Despite such actions, UBS held almost $7 billion of the securities by January, according to the New York suit. When Goldman Sachs (GS), Piper Jaffray (PJC), and others stopped buying them in February, UBS did the same. Within days, the market ground to a halt.

Six months later, many investors, particularly those who owned bonds backed by student loans, are still trying to recoup their money. Some issuers and firms have agreed to buy back the securities. On July 15, UBS announced a plan to acquire up to $3.5 billion of the investments at full value, a deal that doesn't include the student-loan securities. New York Attorney General Andrew Cuomo wants the bank to buy back all $25 billion of the auction-rate securities owned by UBS customers.

First Lutheran's funds, meanwhile, remain frozen. The church rejected an offer from UBS to borrow against the securities. Had they accepted the loan, church members would have given up their right to sue. First Lutheran has filed complaints with Massachusetts and North Carolina regulators. "We were hoodwinked," says Fritz Apple, a 71-year-old parishioner. "They shouldn't have done this, not to a church."

With Brian Grow in Atlanta.

Pressman is a correspondent in BusinessWeek's Boston bureau.