U.S. alleges bait-and-switch scam in auction-rate debt

This article was originally on a blog post platform and may be missing photos, graphics or links. See About archive blog posts.

From Times staff writer Walter Hamilton:

How to sell investors a mortgage-backed security they don’t want: Just don’t call it a mortgage security.

Federal authorities in Brooklyn today indicted two former Credit Suisse brokers, alleging that they tricked large corporations into buying more than $1 billion of so-called auction-rate securities tied to mortgage debt in recent years.

The companies had hired Credit Suisse to invest their short-term cash reserves in auction-rate debt backed by federally insured student loans, according to the indictment. But the brokers instead often placed clients in auction-rate issues backed by subprime home loans and other mortgage-related debt known as collateralized debt obligations -- because those issues paid them ‘significantly higher’ commissions, the government says.

The brokers, Julian T. Tzolov and Eric S. Butler, disguised their actions by falsifying e-mail confirmation statements sent to clients, the government said. The two replaced any mention of the words ‘mortgage’ or ‘CDO’ with ‘student loan’ or ‘education,’ according to the indictment and an accompanying Securities and Exchange Commission civil suit.

For example, one of the brokers placed a client in a $20-million security issued by Greenpoint Credit that was backed by mobile-home loans, according to the SEC. But the broker told the client in an e-mail that the security was issued by ‘Greenpoint Student Assistance.’

The allegations of a bait-and-switch scam are a new black mark for the auction-rate-debt market, which already had become one of Wall Street’s biggest scandals in years.

Auction-rate securities are long-term debt instruments that were designed to trade like short-term securities. The market seized up earlier this year as investors shunned complicated debt issues. The result was that thousands of individual and corporate investors were unable to cash out of the securities.

Major investment banks have reached agreements with regulators recently to repurchase at face value tens of billions of dollars in auction-rate debt that was sold to individuals. But many corporate investors remain stuck in the debt.

In the case the government filed today, Tzolov, 35, and Butler, 36, both of New York, were charged with conspiracy, securities fraud and wire fraud. The securities-fraud count and two wire-fraud counts each carry maximum prison terms of 20 years and $5 million fines.

Attorneys for Tzolov and Butler did not immediately return phone calls seeking comment. The Associated Press reported that Butler pleaded not guilty and that his attorney, Paul Weinstein, said Butler ‘believed he was doing the best for his clients.’ Tzolov was believed to be out of the country.

Credit Suisse said the two resigned last September. The firm said it had suspended them ‘after we detected their prohibited activity,’ according to Reuters.

Most of the companies that bought the debt were based overseas, according to the SEC. The firms are stuck holding at least $817 million in securities that can’t be sold and have fallen in value as the auction-rate market has remained frozen, the SEC said.

Worse, the average drop in market value on mortgage-backed auction-rate securities has been significantly larger than the average loss on student-loan-backed issues.