What the Auction Rate Securities Settlement Doesn’t Do

The New York State Attorney General and the other regulators participating in the auction rate securities (ARS) settlement talks are surely to be commended for their action and diplomacy. Auction rate securities clearly were fraudulently marketed to investors and without the regulatory pressure and investigations; there would be no light at the end of the tunnel. And lest anyone think Wall Street is owning up to its mistakes, know the real reason banks have come to the table are the potentially ruinous emails and evidence that would have surfaced had an investigation continued. The emails that surfaced at Merrill Lynch and UBS showing ARSs were sold to unsuspecting investors while internally it was clear the market was poised to collapse is the tip of the iceberg in all likelihood.

But putting Wall Street’s disingenuous generosity aside for the moment, based on details of that have emerged, it seems to fall short of true retribution for the fraud which occurred…and I’m not referring to Goldman Sachs’ apparent non-participation.

First off, though it appears that brokerages will be buying back auction rate securities over the course of the next year, clients that suffered consequential damages are left out in the cold. Many of our clients were not able to close on transactions such as homes and tuitions because of the ARS market’s collapse. Non-profits were not able to meet their philanthropic obligations as well. Cases seeking to recover these consequential damages are likely to continue in arbitration.

Secondly, ARSs were fervently pitched to corporations as “cash equivalents,” so many very sophisticated CFOs and comptrollers tied up their free cash flows in these securities. Payrolls were missed, financing opportunities passed by and business operations were hampered. These claims will likely proceed as well.

Thirdly, some investors were able to sell their ARSs in the secondary market, usually at steep losses. It’s currently unclear whether they will be compensated for their losses.

And importantly, many angry investors moved their accounts to other firms; and burned brokers, switched firms because their brokerages pressured them into buying and selling auction rate securities. This seems to be a grey area as well. For example, if an investor left Merrill Lynch after getting ensnared in its ARS offerings, and moved his/her account to competitor, it is unclear whether that investor will be made good.

Finally, it appears that Wall Street will be customarily let off the hook by not admitting any wrong doing. At the very least, senior managers who oversaw the ARS market and were responsible for its marketing should be held responsible.

Indeed, when the dust settles on the auction rate securities settlements, its likely Wall Street’s problems won’t go away. As they say, the devils in the details.

Merril Lynch’s Microwave Ovens

The focus on Merrill Lynch these days is on its tattered balance sheet, namely the more than $30 billion in mortgage-related assets it wrote down last week for some 22 cents on the dollar. Given that Merrill valued these toxic assets at 36 cents on the dollar just weeks ago underscores the severity of the mess Wall Street has created. Even a veteran executive like Merrill CEO John Thain has absolutely no clue how to value the assets on his company’s books.

But Mr. Thain has another formidable problem. It is the mind-boggling allegations outlined in the administrative complaint Massachusetts regulators filed Thursday outlining with impressive clarity how Merrill Lynch deceived its clients into believing that auction rate securities were safe cash equivalent investments when in fact they were inherently quite risky. If a significant portion of Merrill’s brokers and retail customers take the time to actually read the complaint, they will be outraged by how badly Merrill’s management betrayed them.

The Massachusetts complaint, impressively written in language that a layman can easily understand, makes clear that Merrill was badly conflicted when selling auction rate securities to its retail customers, some of whom I represent. The firm reaped a hefty $90 million in profits in 2006 and 2007 underwriting these securities for their corporate customers and priced them at interest rates ultimately advantageous to them.

The interest rates on these securities reset at weekly or monthly auctions and were typically slightly higher than an investor could receive from a money-market fund. The little understood risk was that Merrill was artificially propping up the auction rate market and that if an auction ever failed, investors would get stuck holding essentially illiquid long-term bonds carrying relatively low rates of interest. Merrill’s mortgage-related problems eventually prevented the firm from propping up the auction rate market; almost overnight its retail clients were stuck holding low-interest bonds with long-term maturity dates.

“Time after time, when confronted with conflicts of interest, Merrill Lynch was consistent in that it placed its own interests ahead of its investor clients (emphasis mine),” the administrative complaint charges.

With more than three decades of experience representing individual investors who have been wronged by their brokers, it comes as no surprise to me that Merrill put its interests ahead of those of its clients. And to be fair, other brokerage firms also have been accused of deceptively selling auction rate securities to their clients. But the Massachusetts complaint against Merrill also reveals the firm’s lack of regard for both the letter and spirit of previous regulatory agreements it has entered into and provides yet another appalling example of conflicted research.

According to the complaint, Frances Constable, a manager director responsible for overseeing Merrill’s auction rate securities desk, was allowed to compromise the integrity of Merrill’s fixed-income research by demanding that a less-than-sanguine report about auction rate securities be retracted. Merrill’s research department acquiesced and issued a new report positively characterizing auction rate securities as “a buying opportunity.” Merrill cannot claim that Ms. Constable was acting without the complicit approval of her superiors; Ms. Constable sent an email to her bosses written entirely in capital letters outlining her planned course of action.

Another damaging email was sent by Ms. Constable to an associate on November 26 when the firm was clearly worried about the firm’s increasing inability to peddle auction rate securities to its unsuspecting clients: “The gloves are off and we are not concerned about issuer perception of [Merrill Lynch’s] abilities and the competition. Gotta Move these microwave ovens!!”

Conflicted research is nothing new at Merrill. In 2001 the firm was party to a global $1.4 billion settlement after former New York Attorney General Eliot Spitzer uncovered emails showing that then Merrill analyst Henry Blodget was touting stocks he privately believed were “pieces of crap.” As part of the settlement, Merrill agreed to ensure the independence of its equity research department from its investment banking operations. Shockingly, a Merrill spokesman defended Ms. Constable’s actions by saying the Spitzer settlement didn’t preclude communications between Merrill’s sales and fixed-income research analysts.

Artificially propping up its auction rate securities also underscores the disregard Merrill has for regulators. On May 31, 2006, the SEC’s Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms, including Merrill Lynch for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. The penalty: a paltry fine totaling $13 million, of which Merrill’s piece was an insignificant $1.5 million.

To the credit of Massachusetts regulators, they are seeking to force Merrill to make their retail clients whole on the auction rate securities they were duped into buying. But if the Commonwealth’s regulators are truly bent on forcing Merrill to reform, they will insist that any settlement require Merrill to admit wrongdoing, thereby making it considerably easier for their clients to seek redress in securities arbitration for additional losses they sustained because of the unexpected illiquidity of their investments.

The fallout for Merrill’s brokers could also be significant. The complaint alleges that brokers who questioned the safety of auction rate securities were stifled and there is strong evidence that they may not have known or understand the inherent risks of the securities they were selling to clients. Merrill’s brokers could suffer considerable reputation damage if a significant number of clients file claims against them.

Perhaps most damaging of all is that Merrill’s brokers must now accept the hard reality that management ultimately regards them as nothing more than microwave oven salesman.

Bank Stocks the Next Tech-Bubble?

It comes as no surprise that the subprime/credit crunch crisis has led to an increased level of securities class action filings. Research firm Cornerstone just released a report which shows the financial sector was the target of the most filings with 63 in the first half of 2008 alone. The research is an indication that many believe there are disclosure issues which led to inflated stock prices.

But another area of concern is that brokers made speculative plays in these stocks on behalf of their retail clients. Sensing a bottom, many brokers loaded up their clients with stocks like Citigroup, Merrill Lynch, and even Bear Stearns. Trying to catch a falling knife is not an appropriate recommendation for an investor with amoderate or conservative risk profile and we are seeing such complaints become more common.

Clearly, brokers fell asleep at the wheel on two levels: there was no reasonable basis for expecting the financial services industry was finished with its subprime write-downs unless they were duped nor was there any reasonable basis for many investors to buy financial stocks during the past year and a half.

During the tech-bubble, we filed many claims on behalf of investors whose brokers pushed them into bottom fishing for tech stocks that were rightly beaten down. This is another example of Wall Street’s history repeating itself.

Needless to say, any broker who recommended buying bank stocks in the past year and a half should be prepared to explain their rationale in an arbitration hearing.

Lehman’s Investment Banking Prowess

The ways of Wall Street never cease to amaze me.

You might think that a company responsible for orchestrating one of the biggest M&A banking debacles in recent memory, the reputational damage would be quite severe. Think again. In justifying his upgrade of Lehman’s stock, Merrill Lynch analyst Guy Moszkowski cites Lehman’s “very strong global franchises” in various areas, including investment banking.

Investment banking?

Lehman has “bragging” rights for Wachovia’s failed 2006 acquisition of Golden West Financial, a major California thrift and mortgage lender. Analysts estimate that Wachovia could rack up more than $10 billion in losses on Golden West’s $122 billion mortgage portfolio. The botched acquisition is said to have cost Wachovia CEO Ken Thompson his job earlier this week.

Fortunately for Lehman, the brilliant investment banking minds behind M&A deals that go south aren’t called to task. So kudos to Dealbreaker for taking note of Lehman’s additional contribution to Wachovia’s financial woes.

Auction Rate Securities: An Investor Scandal of Significant Proportions

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were “serious and widespread.”

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as “investments” rather than “cash equivalents.” As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.

Chairman Waxman’s CEO Compensation PR Stunt

Next month, Congress will be schlepping in the former chief executives of several financial services firms damaged by the subprime crisis to question them about their compensation packages. House Oversight and Government Reform Chairman Henry Waxman (D-Calif.) has sent letters to Angelo Mozilo, CEO of Countrywide Financial, Charles Price, former CEO of Citigroup and Stanley O’Neil, former CEO of Merrill Lynch. According to reports Chairman Waxman intends to ask them why they “stand to collect tens of millions of dollars in severance payments and other compensation,” even as their current and former companies are losing billions of dollars in the subprime mortgage meltdown.

It’s certainly understandable to perceive these golden parachutes as obscene. Mr. Mozilo is supposedly getting more than $110 million on top of the $47 million he got last year, while Countrywide Financial erased billions of dollars in shareholders equity. Mr. Prince is allegedly getting more than $29 million in “accumulated benefits” and supposedly even received a bonus for 2007. Mr. O’Neal walked away with more than $161 million in “accumulated benefits.” Citigroup and Merrill together have written down more than the GDP of most third world countries.

By any measure, paying these men hundreds of millions of dollars for their recent performance is not justified – which is exactly why Mr. Waxman is calling in the wrong people. It should instead be the corporate board members overseeing the compensation committees that should explain the payouts. Maybe executive compensation consultants hired by corporate boards should face questioning too, such as Hewitt Associates of Lincolnshire, Illinois, and Mercer Human Resources, which were involved in the decision to give Dick Grasso over $100 million. The ones who accepted authorized pay shouldn’t be flogged.

The individuals Chairman Waxman should have sent letters to include Harley Snyder, CEO of HSC, Inc., John Finnegan, Chief Executive Officer of The Chubb Corporation and Alan J.P. Belda, Chairman and CEO of Alcoa, who chaired the compensation committees of Countrywide, Merrill Lynch, and Citigroup, respectively. Hopefully not lost on Chairman Waxman would be the fact that all these men hold the title of CEO. In this elite fraternity, sometimes one hand washes the other. For example, Mr. O’Neil was just named to the board of Alcoa. It would of course be too obvious of a conflict for Mr. Prince to serve on Alcoa’s board, so Mr. Belda got the next best thing. The point is, those holding the power don’t have the motivation to change the status quo.

Chairman Waxman needs to get to the source of the problem which lies squarely with the board of directors and compensation committee members. Not holding them accountable is like patching a leaky roof with duct tape every time it rains. Unfortunately, without their presence next month’s hearings are the equivalent to nothing much more than a witch hunt wrapped-up in a PR stunt.

If Chairman Waxman was truly interested in relating compensation to performance, why stop at publicly held companies? He should call in sports stars like Alex Rodriguez, Carl Pavano, and Albert Belle, notoriously over-paid underperformers. I know what you’re thinking. Congress holding hearings with professional baseball players sounds ridiculous, doesn’t it?

Front Running and Institutional Investors

A few years ago there was a Long Island restaurant that served the most deliciously yummy foods and desserts, all of which were labeled as being ridiculously low in calories and fat. The lines extended out the door. But one night a local television station reported that its testing revealed the restaurant’s food was in fact incredibly high in calories and fat. The restaurant issued an apology and reverted to a healthy menu focused primarily on salads, but barely anyone would frequent the place. The trust was gone and the restaurant closed.

You would think that institutional money managers, who have a fiduciary responsibility to their clients, would also avoid doing business with any firms that engaged in organized wrongdoing and ripped them off. But that certainly doesn’t appear to be the case. There have been repeated incidents where major Wall Street firms reportedly have traded in advance of major trades they were asked to execute for their institutional clients. This practice, known as front running, gives brokerage firms an unfair advantage because they have insider knowledge that a pending block order will likely cause a significant price swing.

The SEC reportedly is investigating whether Merrill Lynch was front running orders placed by Fidelity Investments, the massive mutual fund operator. If the allegations prove true, it won’t be the first time Merrill Lynch has been nailed for this infraction. In 1995 the firm was fined $10,000 and censured by the American Stock Exchange for “the practice of profiting on advanced knowledge of a planned transaction.” The piddling fine didn’t even cover the losses incurred by Merrill’s client and could hardly be considered a major deterrent. Whoever coined the phrase “crime doesn’t pay,” never worked on Wall Street.

But let’s not just pick on Merrill. Front running has long been suspected as a widespread practice at all the big brokerage firms. Yet institutional money managers continue to route the bulk of their trades through them, rather than support the various independent boutiques that have sprung up in recent years offering very sophisticated algorithmic trading capabilities. One of the reasons is that the big brokerage firms offer their institutional clients equity research, but we know that most of that research is hardly worth the paper it’s printed on. Another major reason is simply fear: In the words of one institutional money manager, “no one is going to get second guessed for routing an order through Goldman Sachs.”

Rest assured, even if the SEC finds that Merrill was front running Fidelity’s orders, nothing much will come of it. The matter will be settled by Merrill agreeing to pay a relatively insignificant penalty without admitting any wrongdoing. It will, of course, get to keep most of its ill-gotten gains. The SEC neither has the resolve, or the resources, to take on a big Wall Street firm.

It’s about time mutual fund boards acted responsibly and begin questioning how trading in the equities they oversee are executed. Customers betrayed by the Long Island restaurant weren’t willing to grant a second chance, and I’m confident that mutual investors would be similarly unforgiving about having their holdings routed through institutions engaged in pervasive wrongdoing.

The Subjective Nature of Wall Street Write-Downs

Fourteen billion. That’s the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren’t under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill’s and Citi’s write downs is how it exemplifies the subjective nature of Wall Street’s accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now “retired” CEOs Stan O’Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O’Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe “uncertain market conditions” are to be blamed?

The point is, strategy shouldn’t influence when and how much to write down losses. What Wall Street’s earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street’s books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the “Big Four” accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman’s sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, “This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years’ numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC’s overall compensation.”

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O’Neil has some explaining to do because investors should not accept that Merrill Lynch couldn’t have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street’s favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you’re on a wing and a prayer.