April 18 (Bloomberg) -- Regulators are widening their probes into the collapse of the auction-rate securities market as states from New York to Washington scrutinize how Wall Street peddled the bonds to investors and issuers.

New York Attorney General Andrew Cuomo subpoenaed 18 banks and securities firms including UBS AG and Merrill Lynch & Co. in an investigation that could lead to criminal charges, a person familiar with the probe said yesterday. Officials from nine other states formed a task force to determine whether brokers misrepresented the debt as an alternative to money-market investments when they sold it to individuals.

``To have subpoenas and the threat of criminal investigations raised suggests that somebody has made up their mind that there really are abuses there,'' said Donald Langevoort, a former U.S. Securities and Exchange Commission attorney who now teaches securities law at Georgetown University in Washington. ``It certainly suggests something more than regulatory curiosity.''

Officials are increasing their scrutiny after the $330 billion auction-rate market seized up in February amid the fallout from the subprime mortgage slump, leaving some issuers paying rates as high as 20 percent and investors frozen in the debt. The SEC's inspections office sent letters to the biggest sellers of auction-rate securities this month seeking the names of customers who purchased the notes and the identities of brokers who sold them, according to information obtained by Bloomberg News.

Investor Complaints

``We're all getting complaints on a daily basis from retail investors and they all have the same the story: they were told by their brokers these were safe as cash and they're not,'' said Bryan Lantagne, the securities division director for Massachusetts Secretary of State William Galvin and head of the task force.

In New York, Cuomo is also asking for information about how bankers persuaded borrowers to issue the bonds and how the securities firms decided when to stop bidding in mid-February, the person familiar with the probe said. Dealers had routinely bought unwanted bonds at auctions to prevent failures for two decades.

The subpoenas were issued under the Martin Act, the person familiar with the probe said, giving New York investigators the ability to file criminal charges. The banks Cuomo subpoenaed include Merrill, UBS and JPMorgan Chase & Co., the person said.

Kris Kagel, a spokesman for Zurich-based UBS, and Tasha Pelio for New York-based JPMorgan declined to comment, while Mark Herr, a spokesman for New York-based Merrill, said the company doesn't comment on regulatory matters.

Stock-Probe Echoes

Auction-rate securities are long-term bonds whose interest resets every seven, 28 or 35 days at bidding run by a dealer. They were sold by municipalities, student loan corporations and closed-end funds, most of whom insured the debt against default. Dealers collect fees of about 0.25 percentage point.

Unlike Treasuries or stocks, there is no daily source of information about auction-rate bonds. Issuers have relied on Wall Street dealers to be buyers of last resort when bidders couldn't be found, though the banks weren't obligated to do so.

Since the first of the securities were sold in 1984 for American Express Co., the market has expanded as the bonds offered a higher-yielding alternative to money funds.

Past Investigations

The probe is the third in the market. New York-based Lehman Brothers Holdings Inc. was fined $850,000 in 1995 by the SEC for manipulating auctions conducted for American Express. Almost two years ago, 15 securities firms paid the SEC $13 million to settle claims of bid-rigging. The banks neither admitted nor denied wrongdoing. The SEC also imposed new rules on the market after the settlement.

``They believe they've seen smoke and somebody's complained to them,'' said Thomas Curran, a lawyer at Ganfer & Shore LLP in New York, regarding the latest probe. ``Now they're going to see if there's fire behind the smoke.''

The SEC requires dealers to disclose that they may use insider knowledge to place bids, though they don't have to say how frequently they bid or how much. Dealers also aren't obligated to disclose rates on auction debt when the securities trade.

Demand for auction debt waned this year as investors grew skittish of purchasing securities backed by insurers whose own creditworthiness is under pressure because of subprime-related losses. As buyers backed away, dealers who ran auctions refused to purchase unwanted securities, resulting in thousands of failures.

Penalty Rates

When an auction fails, rates are set at a penalty level spelled out in bond documents and investors who wanted to sell are left holding the securities. More than 60 percent of public auctions held each day since Feb. 13 have failed, according to Bloomberg data.

The average rate on seven-day securities jumped as high as 6.89 percent on Feb. 20 from 3.65 percent on average last year. It has since declined to 5.14 percent.

``I don't think anyone ever imagined that these auctions would fail,'' said Jorge Irizarry, president of the Government Development Bank of Puerto Rico, whose interest costs rose to as high as 12 percent on failed auction debt.

Puerto Rico is planning to convert all of its $643 million in auction bonds to other securities by month-end, joining states, cities, hospitals and colleges who have converted or are planning to replace at least $43.1 billion of the securities by next month, according to data compiled by Bloomberg.

Never Again

Citigroup Inc., the biggest underwriter of municipal auction debt from 2000 to 2007, this week predicted the market will ``cease to exist.''

``Obviously we would never go into the auction-rate market again,'' said David Verinder, chief financial officer at Sarasota Memorial Hospital in Sarasota, Florida, which recently converted $165 million in auction debt.

Citigroup today said it took $1.5 billion of writedowns on auction debt in the first quarter as it posted its second straight quarterly loss. UBS last month cut the value of auction securities held by its customers by about 5 percent.

Galvin's office in Massachusetts subpoenaed information from UBS, Merrill and Bank of America Corp. regarding the sale of the securities to investors in the state.

In addition to Massachusetts, the state task force includes Florida, Georgia, Illinois, Missouri, New Hampshire, New Jersey, Texas and Washington, according to the North American Securities Administrators Association. Other states are prepared to participate in the task force, Lantagne said.

Federal Regulators

The SEC said last week it is working with the Financial Industry Regulatory Authority to examine firms' disclosures to clients who purchased the bonds.

Besides Citigroup, UBS, Merrill, JPMorgan, and Bank of America were among the 10 biggest underwriters of auction-rate debt from 2000 to 2007. The other five are Lehman, Bear Stearns Cos., Goldman Sachs Group Inc., Morgan Stanley and RBC Dain Rauscher.

Spokespeople at Lehman, Bear Stearns, Goldman, Morgan Stanley and Citigroup declined to comment. Chris Nietupski, a spokesman for RBC Dain Rauscher, didn't return a call seeking comment, nor did Shirley Norton of Charlotte, North Carolina- based Bank of America.

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net.

Last Updated: April 18, 2008 14:47 EDT