State was warned on securities
But individual investors were surprised by failure of auction-rate market
At least five major Wall Street firms warned the Commonwealth in January that a $330 billion slice of the bond market was in distress, e-mails and presentations from those firms show. They were warnings that most individual investors did not receive before the market collapsed on Feb. 13.
The troubled bonds were auction-rate securities, investments that have prompted two regulatory actions in Massachusetts against UBS Financial Services Inc. The Massachusetts Securities Division last week charged UBS with fraud for failing to warn individual investors and its own brokers that the market was on the brink of failure.
Now it appears that several other firms - JP Morgan Securities Inc., Lehman Brothers, Morgan Stanley, Bear Stearns Cos., and Merrill Lynch & Co. - also knew the auction-rate market was in trouble ahead of time. In the weeks leading up to the collapse, each of the firms told the state treasurer's office that the market was faltering, sometimes in dire terms, according to documents obtained in a public records request.
Massachusetts Treasurer Timothy P. Cahill said the investment banks were doing their job by warning the state of the turmoil in the auction-rate market. "The fact that they weren't providing the same advice to smaller investors, and even some smaller state entities, is unforgivable, really," he said.
As early as Jan. 10, Bear Stearns, mired in troubles that would soon bring down the firm, told the state in a presentation: "As discussed in previous meetings," credit and liquidity concerns have "resulted in a dislocation in the market for auction rate securities."
On Jan. 15, Lehman Brothers warned that brokerage firms were using their own money to keep auctions from failing. But it noted "severe constraints" on the firms' balance sheets.
By Feb. 11, two days before the market froze, JP Morgan sent research to the state that offered the bluntest assessment yet: "We would not be surprised if these recent failed auctions began to breed like rats, begetting more fails . . ."
The firms were urging the state to refinance its $565 million in auction-rate debt into other kinds of bonds. Auction-rate securities are primarily bonds issued by municipalities and nonprofits, like student lenders. For years, they had been an inexpensive way for those entities to borrow money to fund their operations and a decent investment for people seeking returns slightly better than money markets. Brokers across the industry sold them as cash-like investments, because customers historically could get out of them every seven or 28 days. The interest rates on the debt reset at each of those auctions.
But brokers didn't know what their colleagues on the investment banking side of the house seem to have known: that the investments were about to become far from cash-like.
All the firms except Merrill Lynch declined to comment for this story. Merrill's Jan. 11 notice to the state was milder than those from the other firms, warning that interest rates were rising on the debt, due to "weakening demand."
In a statement, Merrill said, "Given the increasing interest rates on the state's debt, we believed the refinancing would reduce the state's borrowing costs and save taxpayers money."
It also was almost certainly in the investment banks' interest to get clients to refinance, because they had significant capital devoted to propping up the auction-rate market. The state's complaint against UBS cited an internal e-mail from Dec. 12, in which a UBS executive wrote, ". . . we need to use our leverage to force the issuers to confront this problem."
Treasurer Cahill said, "My experience is, the banks do what's in their best interest. You have to be very diligent on your own to make sure that your interests are being served."
Some investors are angry that the state and other issuers of auction-rate debt did not react more quickly to the warnings. Harry S. Miller, a lawyer at Burns & Levinson in Boston who is representing some investors, said, "There's enough blame to go around."
First in the line of responsibility, Miller said, are the brokerage firms that sold the securities without warnings. But the state has some responsibility as well, he said. Investors have some $220 billion stuck in these investments, according to Capital Advisors Group Inc. in Newton. "At a certain point, you have to look at a state administrator and ask if they did their due diligence," Miller said. "They've got the citizens of the state to be concerned about."
Cahill said even his office didn't fully realize the magnitude of the problems to come. "We're in a new world right now. What used to be considered safe, liquid investments are certainly not liquid right now."
About 3 percent of the state's outstanding debt was issued in auction-rate securities. The treasurer said the debt would be refinanced within the next month.
"We certainly don't want to be in them and tie up people's money," Cahill said. "We're not getting hurt. But we think it's in everyone's best interest if we refinance."
Seventeen Massachusetts cities and towns and the Massachusetts Turnpike Authority bought auction-rate securities from UBS, without understanding the risks. UBS agreed to repay them $37 million in a May settlement with state Attorney General Martha Coakley.
Other investors in auction-rate securities have not been so fortunate. While the brokerage firms were warning clients like the state that the market was collapsing, individual investors were taken entirely by surprise. Most firms listed the securities on their statements under cash, changing them to a riskier category only after the auction-rate market failed.
The warnings to the treasurer's office grew more direct as the crisis worsened. In a Jan. 23 e-mail, a Morgan Stanley executive wrote, "The auction rate market continues to come under significant retailing pressure," and cited four failed auctions.
By Feb. 8, JP Morgan sent a memo saying the auction-rate market "has gone through a fundamental shift, and many market participants have lost confidence in the product's ongoing viability."
In the JP Morgan research report of Feb. 11, discussion of auction-rate securities came under the heading, "Smelling Rats," and predicted, "If the pace of failed auctions increases, there will be widespread market impact."
Only five days later, all trading in the securities would stop.
Beth Healy can be reached at bhealy@globe.com. 