Tue, August 05, 2008
UBS Settles with MA Over Auction-Rate Security Misunderstanding
Several MA cities, towns, and the Mass Turnpike Authority received some investment help from Attorney General Martha Coakley recently. Although it's often assumed that institutional investors are sophisticated in their understanding of investments, the case initiated and settled by the Massachusetts AG shows that even "big" investors sometimes fail to follow one of the cardinal rules of investing: make sure you understand what you're investing in.
Giant Swiss financial services company and investment bank UBS agreed to cough up about $39M invested by the Massachusetts Turnpike Authority and twenty-one cities and towns, plus an additional million to cover UBS's fees and to pay for a program to teach state officials how to invest taxpayers' money properly. The officials invested money in bonds known as auction-rate securities (ARS) with the idea that they were parking their money in safe, liquid investments - sort of like money market mutual funds. The bonds offered rates higher than conventional money market funds, and this made them an attractive place to invest short-term funds.
The problem is that auction-rate securities aren't really short-term bonds – they are long-term debts whose interest rates are reset through an auction process that may recur as often as once a week. The minimum ARS investment size is $25,000, so the buyers are typically either wealthy investors or institutions. As long as the auction process is successful, the bonds work well. What municipal officials apparently didn't understand was that the auction process is not guaranteed. In the event that there aren't enough buyers, the value of the shares may have to be marked down. In other words, the owners of the securities risk losing some of their principal. Since these securities are often highly-rated, the officials thought that they were putting taxpayer’s money into safe investments.
When a number of ARS auctions failed earlier this year, UBS marked down the value of several of its offerings; some were cut by as much as 20%. Since 20% is a pretty big hit for a “safe†investments, several lawsuits have been initiated against UBS and other banks that acted similarly.
It's hard for me to say which side is most at fault. Is it UBS AG, the largest manager of private wealth on the planet, which allegedly led investing institutions to believe that it would always intervene to ensure that ARS auctions never failed? Is it the presumably sophisticated institutional buyers, entrusted with taxpayer funds, who apparently didn't read the fine print for the securities they bought?
The scariest part of the settlement is the provision of $250,000 to pay for "education, training and assistance for treasurers and other financial officials of [Massachusetts] cities and towns with respect to appropriate investments, investment management practices, and financial controls." Hmmm.
UBS apparently decided that it was better not to debate the case too long. UBS is also being sued by NY Attorney General Andrew Cuomo, so the poor - I mean, imprudent - bank will probably need to crank up its legal budget for Q3.