Citigroup pays big for shoving risk under the rug

Here's what fueled much or maybe most of Wall Street's growth over the last few years: Investment banks (and by that I also mean the investment banking arms of giant banks like Citigroup and UBS) found ever more ways to sell gobs of risky securities while

a) telling the buyers they weren't risky, in many cases because the investment banks implicitly or explicitly committed to stand behind them if things went haywire

and

b) telling their own shareholders that these securities had been sold to others and were thus no longer a risk to the company

and

c) telling regulators more or less the same things they told shareholders.

In other words, the investment banks were booking big profits while shoving all the related risks under the rug. And now that's coming back to bite them, as it did Citigroup today when the firm agreed, under pressure from New York Attorney General Andrew Cuomo, to (in the words of a couple of Bloomberg reporters) "buy back or help clients unload $19.5 billion in auction-rate securities and pay a $100 million fine to settle U.S. regulatory claims it improperly saddled customers with untradeable bonds."

Auction-rate securities are bonds, mostly municipal bonds, with interest rates set every week or every several weeks at an auction. Because short-term interest rates are usually lower than long-term interest rates, this allowed issuers (cities, states, port authorities, etc.) to pay less in interest than they would have otherwise. But this February, investors spooked by global financial turmoil decided to stay away from a couple of regular auctions. The investment banks that arranged the auctions opted not to step in and buy bonds to keep the auctions going, and interest rates on the bonds suddenly skyrocketed--from 4.3% to 20% in the case of one set of bonds issued by the Port Authority of New York and New Jersey. After that, the auction-rate market effectively shut down. Issuers were stuck paying high interest rates--although many have since refinanced their debt into non-auction-rate bonds--and those who bought bonds before the market freeze-up were stuck with hard-to-unload securities. The bonds themselves weren't and aren't very risky. But the investment banks, after persuading both buyers and sellers that there would always be a liquid auction-rate market, failed to do their part to keep trading going.

Now Citi has been shamed into taking responsibility for the bonds it underwrote. Other investment banks will surely follow. That's a good thing--for investors, for issuers, and for the long-run credibility of Wall Street.

But one does have to worry that:

a) this will end up up costing already-reeling banks and investment banks a whole bunch of money

b) while we've now been through blowups in mortgage CDOs, auction-rate bonds and bond insurance, there may be more such risk-hiding escapades still to be fully exposed

and

c) if Wall Street firms are careful and shy away from such shenanigans in the future, they won't be able to report anything like the kind of profits they did over the past half decade.

Update: Felix Salmon makes an important point (that partly contradicts my point):

The problem with auction-rate securities was maybe this: that stockbrokers felt a huge amount of pressure to reassure a bunch of investors with, typically, six-figure sums of money to invest that their money was perfectly safe and perfectly liquid. There's no such thing, and frankly people should stop being so cavalier about money-market accounts as well. If you've got lots of money, good for you. Now go and invest it sensibly. Don't ask for zero risk. That way lies trouble.