Aug. 19 (Bloomberg) -- JPMorgan Chase & Co., one of five banks to settle claims they misled investors who bought auction- rate debt, told California days before the market collapsed to be ``vigilant'' to the potential of further deterioration.

``The State must remain vigilant going forward because of the continued possibility of failed auctions,'' the New York- based bank wrote on Feb. 1 to State Treasurer Bill Lockyer.

The $330 billion market for auction-rate securities collapsed on Feb. 13 when the Wall Street banks that ran the sales stopped propping up the market by using their own money to bid for unwanted bonds, a practice that had prevented auctions from failing during the market's three-decade history.

The collapse surprised thousands of investors, who found their money stuck in securities they couldn't sell. JPMorgan and UBS AG are among the banks that have agreed to buy back bonds and pay fines to settle with state and federal regulators who say the banks misled investors by selling auction-rate securities as liquid alternatives to cash even as the market veered toward collapse.

Lockyer received similar advice about the market's growing trouble from Zurich-based UBS and Bank of America Corp., based in Charlotte, North Carolina, as early as November, according to memos released today by the treasurer. Of the three, only Bank of America hasn't yet settled complaints it fraudulently marketed the long-term bonds as the equivalent of cash even as the market faltered.

Heeding Signal

``We heeded the negative signals that were in the market,'' Lockyer's spokesman, Tom Dresslar, said in an interview today. While the state began plan to refinance the debt in early January, it didn't pass along the warnings to other issuers in California, he said. The state refinanced $1.25 billion of the securities in the weeks after the market collapsed.

Brian Marchiony, a spokesman for JPMorgan, declined to comment, as did UBS spokeswoman Karina Byrne. Bank of America spokesman Jon Goldstein also declined to comment.

UBS said in a Nov. 30 memo sent to Lockyer's office to ``expect auction-rate yields to continue creeping up'' through March 2008. On Dec. 7, UBS said ``We see continued pressure on ARCs, and expect further rate deterioration,'' referring to auction-rate certificates.

Bank of America told Lockyer in a Dec. 17 presentation that there was ``significant uncertainty'' surrounding demand for the securities because companies were selling the debt and ``new retail demand is a little weaker,'' a reference to individual investors.

`Reviewing Exposure'

Bank of America's warning was reported today by the Boston Globe, which last month said JPMorgan, Lehman Brothers Holdings Inc., Morgan Stanley, Bear Stearns Cos. and Merrill Lynch & Co. warned Massachusetts Treasurer Timothy Cahill about faltering auction-rate demand as early as Jan. 10.

JPMorgan's memo said ``issuers are reviewing their current exposure and considering whether the time may be right to exit the ARS market for another mode with less volatility or risk.''

By then, the yield on one series of the state's auction-rate securities was 3.58 percent, compared with a market average of 2.2 percent on variable-rate municipal debt, the bankers said in the memo. Even so, California should stay in the market unless demand worsened.

``Should conditions change, JPMorgan is available and stands ready to assist the State,'' the bankers wrote.

JPMorgan agreed on Aug. 14 to buy back $3 billion of auction-rate securities and to pay fines of $25 million. UBS, Switzerland's biggest bank, said on Aug. 8 that it will redeem $18.6 billion of debt and pay $150 million in penalties. Morgan Stanley, Citigroup Inc. and Wachovia Corp. have also agreed to settlements.

Municipalities, student loan organizations and closed-end mutual funds used the auction-rate market for more than two decades, selling bonds maturing in as much as 40 years with interest rates set every seven to 35 days.

New York State Attorney General Andrew Cuomo, the U.S. Securities and Exchange Commission, and other state regulators have been investigating the banks.

To contact the reporters on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net; Michael B. Marois in Sacramento at mmarois@bloomberg.net

Last Updated: August 19, 2008 20:59 EDT