UBS: Auction-Rates Securities Collapse

UBS has been charged with manipulating the auction-rates securities market before its collapse

by Aaron Pressman

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Trouble Brewing: Internal documents suggest UBS may have seen problems

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Illustration by Chang Park

Ever since the auction-rate securities mess erupted six months ago, the same story has echoed across Wall Street. The way UBS (UBS) and other banks tell it, the $330 billion market functioned for years without a hitch, providing big corporations and wealthy investors with a highly liquid alternative to cash. Then, without warning, it imploded in February, leaving tens of thousands of investors with huge losses if they tapped their accounts—assuming they could get the money at all.

But a BusinessWeek analysis, based on court documents and interviews with regulators, investors, and financial advisers, reveals that there were serious flaws in the market long before it seized up. Last summer's credit crunch, which scared off investors from all manner of debt, only exacerbated the problems. There could be legal consequences for UBS, which is being sued for fraud by regulators in Massachusetts and New York. UBS, one of the biggest underwriters of the securities, says the cases are without merit and that e-mails cited in the suits are taken out of context. (On July 30, UBS settled a separate investigation by the Massachusetts Attorney General into sales of the securities to the state's municipalities.)

Over the years, auction-rate securities became popular among investors looking for cash-like options with slightly higher yields than money-market funds and certificates of deposit. The investments—in reality, long-term bonds—were considered more like short-term debt because they could usually be sold at weekly or monthly auctions. Until February, UBS and other banks kept auctions from failing by stepping in to buy any unpurchased securities. But when buyers fled amid the credit crunch, the bank bought more than it could handle. The Massachusetts suit alleges that despite the turmoil, UBS continued to hype the investments as high quality, pushing in-house brokers to sell them. "UBS categorically rejects any claim that the firm engaged in a widespread campaign to move…inventory from the firm's own books and into private client accounts," says a UBS spokeswoman.

Like other customers, the First Lutheran Church of Greensboro, N.C., wanted a safe place to stash some money. After raising $500,000 to build new classrooms and an addition, church leaders invested the money in auction-rate securities on the recommendation of their UBS broker, a member of the parish. "UBS told us they'd put the money in conservative investments to preserve our principal," says church president Andrew Chamberlin.

But when officials tried to withdraw money in May, the bank told them the funds were frozen. "We believe at the time the Church made the…investments, the purchases were suitable," a UBS lawyer told First Lutheran in a June 20 letter. "However, as a result of unprecedented instability in the…markets, there recently have been numerous…auction failures."

Court documents suggest, however, that UBS may have known about problems with the securities months, and even years, before the market disintegrated. UBS, Citigroup (C), Merrill Lynch (MER), and others, which collected huge fees for running the auctions, habitually intervened: When enough buyers didn't show up, firms bought the leftovers to keep the auctions going. From January 2006 through February 2008, UBS bought securities at 88% of the 30,000 auctions it ran for towns and student loan authorities. In 2006, the Securities & Exchange Commission fined 15 other brokerages, including Citi and Merrill, $13 million for failing to disclose that they sometimes supported the auctions. Citi and Merrill declined to comment.