Friday, April 13, 2012

Reno Isn't Goldman Sachs' Only ARS Victim

Yesterday, News 4 Reno did a quick piece on it.

But as we discussed yesterday, there's far more to this story than what initially meets the eye. Apparently, Goldman Sachs convinced Reno to issue $210 million in "auction rate securities" that ultimately cost the city far more than Goldman told them once the 2008 financial crisis hit and the "auction rate securities" (ARS) market turned out to be far less stable than Goldman claimed it was. In fact, it looks like Goldman has run into trouble on this issue before.

Last year, Goldman Sachs had to settle a law suit with Colorado's Division of Securities and buy back over $5 million worth of ARS after investors there complained about their inability to sell once the ARS market was frozen. And after New York's Attorney General began investigating Goldman in August 2008 over concerns that they pushed Fidelity Investments to sell Goldman underwritten ARS to investors, Fidelity agreed less than a month later to buy back $300 million worth of ARS from its customers.

Back in February 2008, just as the entire ARS market was starting to crash, The New York Times probed what was happening behind the scenes... And did this story that sounds awfully prophetic today.

In 2006, the Securities and Exchange Commission reached a $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market.

The S.E.C. investigation centered on how bidding was conducted for these securities. Critics complain that investment banks have the upper hand in bidding because they can bid after seeing what other investors have bid.

Brokerage firms are not legally obligated to make a market in auction securities, or give clients a price even if there is not one in the market. But clients who are unable to sell are likely to argue that they were wrongly put into long-term securities when their intention was to buy shorter-term debt.

“If these were pitched as cash equivalents, if that is what the broker said they were, the banks may be held responsible for losses and clients’ inability to get their money out,” said Jacob H. Zamansky, a securities lawyer who represents individual investors.

Goldman Sachs and Merrill Lynch declined to comment.

The situation is an awkward one for investment banks and brokers that have had to tell clients that their cash is frozen until at least the next auction — if not longer. One affluent New Jersey family has sued Lehman Brothers for the declining value of its cash in auction-rate securities. Lehman has said it acted properly.

Money managers, chief executives and individual investors have been swept up by the latest turmoil in the credit markets. One wealthy investor said Goldman Sachs had sold him auction-rate securities and had described the instruments as equivalent to cash.

“It’s a moral outrage,” said this investor, who asked not to be named because he still has to deal with the bank. “Their pitch was, keep your cash with us, we get a higher rate.”

And this brings us back to Reno. Remember that in 2005 and 2006, Goldman Sachs was telling the City of Reno that ARS were essentially as good as gold when Goldman convinced Reno to issue that $210 million in ARS for the events center and railroad trench projects.

The city is seeking arbitration against the bank through the Financial Industry Regulatory Authority (basically, a private court for financial institutions), “to recover the damages it sustained due to Goldman’s misrepresentations and omissions” when the city issued the bonds in 2005 and 2006 for its downtown events center and railroad trench projects, according to complaint filed in February. Those bonds were issued on the so-called “auction rate securities” market, which collapsed amid the global financial meltdown in February 2008. [...]

Cities figured that would result in lower interest rates over time and investors thought they could get a liquid investment at higher interest rates compared to other liquid investment options like money market funds.

What cities and investors didn’t know, according to state and federal court filings against banks involved in the auction rate securities market, was the extent the market relied on the financial institutions to keep it running.

In other words, the banks were keeping the market alive by bidding on the bonds, too — and didn’t tell anyone. So when the banks stopped making those bids in February 2008 as the credit crunch began to squeeze the financial system, Reno’s interest rates spiked on the downtown events center bond and forced the city to drain a $5 million reserve fund to cover interest payments that jumped to 15 percent overnight. The city was also forced to pay millions of dollars in fees to the bank to refinance the debt.

Reno’s filing with FINRA says had the city known the market was so dependent on banks like Goldman Sachs — the Biggest Little City’s big bank of choice throughout much of aughts — it would have thought twice about issuing the debt on the auction rate securities market.

“…Goldman’s actions, misrepresentations and omissions demonstrate that it dd not deal fairly with Reno, and as a result Reno sustained extensive damages,” according to Reno’s filing.

So Reno thought that ARS would save them money over a traditional bond sale while still providing the city with needed funding for its infrastructure projects because Wall Street powerhouse firm Goldman Sachs told the city so. And investors thought ARS were "solid and safe" because Goldman Sachs told mutual fund providers like Fidelity to tell them so. What neither side knew was that both sides were being played as "Muppets", as former Goldman Sachs insiders Greg Smith and Jacki Zehner would later admit.

Here's Greg Smith in his own words (from his own New York Times Op-ed):

What are three quick ways to become a leader [of Goldman Sachs]? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus,God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

So the City of Reno may just be one of a multitude of ARS victims played by Wall Street "vulture capitalists" like Goldman Sachs. The Reno case just may be the first time that a municipality convinced into selling ARS seeks compensation for subsequent losses. And strangely enough, Reno may now be providing the Occupy/99% movement with something far more valuable than a pool complex to organize around.

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