Monday, July 14, 2008

Brokers Target of Criminal Investigation in ARS Scandal

First the State of Mass. went after UBS. Now Federal prosecutors are investigating whether two former Credit Suisse Group brokers lied to investors about how they placed their money into short-term securities.

Obviously the ARS issue is a hot topic, but I am concerned at the attempt to criminalize the conduct of individual brokers, when it appears that the ARS marketplace was as close to a fraud as one could imagine. Just read the emails that are attached to the UBS Complaint annd it becomes clear, assuming of course that the emails are accurate, that 1)the firms knew that the ARS market was collapsing in late 2007, and 2) they pushed brokers to move the securities out of the firm's inventory to its retail customers.

It is quite a stretch to hold the retail broker liable for the ARS debacle, as brokers are relying on their firms for the details of the securities that they sell. The rumors are that the brokers told their customers that the underlying securities were student loans, when in fact they were CDOs. The WSJ is making a big deal about that distinction, but IMHO, that is insignificant. Granted, CDOs carry more risk than student loans, but if that is the fraud, then prosecutors are going to walk away without a conviction, since the underlying securiteis are not in default, it is the auctions that failed, and those auctions failed regardless of the nature of the underlying paper.

OTOH, depending on how savvy the investor is, that distinction might just be material. I have a hard time believing that the average Joe, parking cash in an ARS knew or was concerned about the underlying paper, and therefore the elements of materiality and reliance would be missing from the criminal case.

Are we again going to see brokers taking the heat for a firm's fraud? Too many brokers were destroyed in the research scandal, and many fear the outlash against brokers for this debacle....even though most brokers who were involved with these securities knew as much about the underlying problems as their customers knew.

Of course, at issue is the $330 billion market for "auction rate" securities, which have now become illiquid.
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