WASHINGTON - Fidelity Investments and Charles Schwab & Co. are suggesting state and federal securities regulators focus their auction-rate securities investigations on the major banks and broker-dealers that underwrote ARS rather than smaller brokerages that had no advance knowledge that the ARS market was going to collapse.
Reacting to requests from state regulators that they buy back at par the now-illiquid ARS their brokerage units sold to retail customers as safe securities, representatives of both Fidelity and Charles Schwab stressed yesterday that their companies did not underwrite the ARS products and said they did not mislead customers about ARS.
"With respect to auction-rate securities, Fidelity is neither the issuer, underwriter, or the sponsor of these securities," said Vincent Loporchio, a spokesman for Fidelity Investments. "Unlike some other firms, Fidelity does not proactively market auction-rate securities nor does it maintain an inventory of these securities."
He added that the firm has included information about the possibility of failed auctions of ARS on its Web site since 2006, when it began offering the securities, and that only a small number of Fidelity retail customers own ARS.
Greg Gable, senior vice president at Schwab, emphasized that the firm had no role in the auction process and only distributed them at the request of its customers.
"It's important to know that unlike other firms that have been in the news related to auction-rate securities, we didn't underwrite these products, didn't market them to our clients, but simply acted as an agent as an accommodation when clients asked for them," Gable said. "A significant portion were simply transferred in from other firms where they were purchased."
He added that multiple regulators have asked the firm to provide ARS information and it is cooperating with the requests.
The firms appear to echo similar arguments made this week by the Regional Bond Dealers Association, which wrote letters to state and federal regulators Monday that pointed out that the five ARS settlements reached recently are faulty because they exclude investors who purchased the securities through secondary regional firms that merely distributed the ARS and had no control over the auctions.
The RBDA and its members have become increasingly concerned that the settlements don't include the roughly $60 billion of outstanding ARS purchased through smaller firms because the regulators still plan to bring legal action against them. The RBDA said the firms that the big firms that underwrote and sold the ARS should be responsible for providing relief to the investors who purchased the securities through the smaller firms that merely distributed them.
The next day, Massachusetts Secretary of the Commonwealth William Galvin urged Fidelity to buy back now-illiquid ARS its brokerage unit sold to retail customers as safe securities, mirroring the buy-back plans that five large firms have agreed to in recent weeks.
"It is my hope that Fidelity will follow the industry trend and promptly repurchase these securities that it has sold to its customers, many of whom now find themselves unable to access money that they thought was as liquid as cash," Galvin wrote in the one-page letter, which was sent to Edward Johnson3d of Fidelity Management & Research Co., and to Fidelity Brokerage Services LLC, which are subsidiaries of Fidelity Investments.
In late June, Galvin sued two UBS AG subsidiaries for selling its retail investors auction-rate paper as "liquid, safe, money-market" instruments even though the Swiss-bank's officials knew it was not. Late last month, he sued Merrill Lynch & Co., charging that sales and trading managers altered their research department's reports on ARS to minimize the risks of the securities and to forestall a collapse of the $330 billion market. UBS settled with Galvin, New York Attorney General Andrew Cuomo and the Securities and Exchange Commission this month, while Merrill is said to be taking part in some settlement talks.
In Tuesday's letter, Galvin referenced his two lawsuits, warning: "The fact that this office has addressed its concerns with respect to the largest sellers of auction-rate securities first should not be misconstrued to suggest that I am not equally as concerned that all investors who find themselves stuck with these illiquid securities are made whole."
Galvin's letter comes after Cuomo said last week that he is extending his investigation of the collapse of the ARS market to Fidelity and Charles Schwab. Galvin's investigation is part of a multi-state task force probing about a dozen firm's ARS sales practices. Cuomo has opted out of the task force and is said to have over 20 investigations underway, while the SEC has 12 open cases.
Meanwhile, on Tuesday California Treasurer Bill Lockyer released memos state officials had received from UBS, JPMorgan, and Bank of America last year in which the dealers warned weeks before the ARS market collapsed that there were significant problems in the market.
A Feb. 1 memo from JPMorgan warns that the ARS market "has experienced a significant dislocation" stemming from its exposure to monoline insurers, the lack of investor liquidity "put" options, and other things. The firm noted the state "benefited greatly" from the fact that it did not insure its ARS transactions.
However, it added, "The state must remain vigilant going forward because of the continued possibility of failed auctions."
But the memos do not warn that the firms were preparing to exit the ARS market and would soon stop bidding in the auctions.
As the five banks move forward with settlements to buy back a total of about $47.4 billion of ARS from retail investors, some market participants are questioning how banks' balance sheets will be affected by the settlements. The banks may find it difficult to raise money to fulfill their settlement agreements with state and federal regulators, they said. The banks also may be forced to take writedowns if they are stuck holding ARS on their balance sheets. Some firms, such as Merrill, have said the buy backs would have a "de minimis," or minor, impact on their balance sheets, but sources said their lack of options for buying and selling ARS could prove these claims to be optimistic.
The firms' first option could be to issue debt with long-term interest rates to fund the buyback programs, market sources said. They could fund the interest payments with short-term rates received on any ARS they hold. But the firms will loose money on the difference, said one analyst who asked for anonymity.
Primary dealers could turn to the Federal Reserve's discount window, which remains open to non-commercial banks, and offer ARS as collateral. But the Fed may not accept the ARS at par, and firms could suffer losses on the difference, the source said.
One option may be to sell their ARS through online brokers. Retail investors, who are willing to take risks with the often illiquid securities, could buy ARS from firms through online platforms like the one run by The Muni Center LLC.
But John Kraft, director of business development for Municenter.com, said the ARS market is "totally dead." The online broker was matching buyers with sellers of ARS on a "bulletin board" before and after the market collapsed in February, he said.
"The broker-dealers weren't interested in making bids on other people's [ARS] when they had their own customers who were looking for the same thing - liquidity," Kraft said. "The dealers were trying to take care of their own customers and weren't supporting anybody else's product."
The technology "opens up the market place so that investors wishing to unload a position have a world of other investors," said Peter Chatzky, founder and president of the Napa Group LLC, which provides technology for online broker platforms.
But a widely available online platform for all, not just muni, ARS is still a work in progress. The New York Stock Exchange, which offers a bond trading platform, said it does not handle ARS and has not discussed offering the ARS with any of the firms that have agreed to settlements. Municenter.com also said it has not been contacted by the firms to use the platform to sell ARS.
Rich Saskal contributed to this story.