The auction rate securities market imploded last year as the credit crunch started to hit in earnest. These securities were sold to investors as cash equivalents because theoretically they could be redeemed on short notice. Auctions were held at regular intervals, usually weekly, and investors were assured they could sell their securities at the auctions. That turned out to be true until, well it wasn’t. The underwriters had always acted as bidders of last resort at the auctions but as their losses in the mortgage market mounted, they walked away from the auctions. Investors who thought they had short term liquid investments were left holding the bag. Now a lot of investors, who planned to use this money for things like college tuition, can’t access their funds.

Most of the large banks who sold these securities have agreed to buy them back from investors starting next year, so eventually most investors will get their money back. It doesn’t cover everyone yet but it should. The banks knew these securities weren’t liquid and as the market started to fail, some increased the compensation they paid brokers to push them (via Bloomberg):

Citigroup increased the commission its financial advisers earned selling the bonds to investors as the market stalled.

“Just make sure all hands are on deck and paper is sold,” an unidentified Citigroup official wrote in an e-mail cited by the SEC in a complaint where it accused the bank of misrepresenting the risks of buying the debt. “Times like these, we need to do whatever is necessary.”

Why were the banks continuing to push auction rates?

“The fools in this trade are the dealers that perpetuate the structure because they are intoxicated by the fees,” the head of UBS’s municipal securities group, who wasn’t identified in the document, wrote in December.

Investment banks also earned more than $1 billion over two decades underwriting the auction-rate market, based on average fees paid for the services. Most states and local governments entered into interest-rate swaps after selling the securities, generating additional fees for the banks, Joseph Fichera, chief executive of New York-based Saber Partners LLC, said at a public finance conference in October.

Citigroup investment bankers wanted to keep selling new auction-rate securities even as demand tumbled last year in order to keep earning the fees and maintain their top underwriting spot, according to the SEC complaint. The firm didn’t curtail new issuance until November, the SEC said.

Brokers get paid to sell products. When dealing with them it is wise to always keep that in mind. It is not fair to blame your local brokerage house representative though. In most cases, they aren’t in the loop. Most of them were just as surprised as their clients when the auctions failed. Their firms on the other hand, should be held reponsible. They knew and just tried to keep collecting commissions.

And Citigroup? Can they do anything right? Are they at the center of every scandal? Just stay away….