June 26 (Bloomberg) -- Yanping Cui, 57, says she invested in auction-rate bonds last December at the urging of a broker at UBS AG in Long Beach, California. The same month, UBS told one of the issuers of those securities, a New Hampshire student-loan agency, that the $330 billion market was in danger of failing.

That's exactly what happened in February, when mounting mortgage losses forced dealers who underwrote and managed the market for more than 20 years to stop acting as buyers of last resort. Cui was told she wouldn't get her money back until the market recovered.

``He said it's very safe and as liquid as possible,'' Cui said of the advice she received from UBS broker Brian Meehan. ``I'm so angry. That's my bloody money.'' Meehan, now at Wells Fargo Investments in Newport Beach, declined to comment.

Cui is one of dozens of investors who say they were sold auction-rate securities as a low-risk alternative to cash at the same time underwriters, including UBS and Citigroup Inc., were telling issuers that demand was softening, bond documents and interviews with investors show.

The chronology shows that dealers ``knew they didn't have enough demand,'' said Christopher ``Kit'' Taylor, executive director of the Municipal Securities Rulemaking Board from 1978 to 2007, who now consults investor groups on financial markets and regulation. ``They were not telling the other side of the story.''

Massachusetts Charges

At least 24 proposed class-action lawsuits have been filed against brokerages since March, and a nine-state task force is examining how the firms marketed the securities. Those burned in the meltdown see it as a case of Wall Street hiding known risks from investors, much like the dot-com scandal over former Merrill Lynch & Co. analyst Henry Blodget, who once advised buying a stock while privately calling it ``junk.''

``Everybody was just rolling into this market and trading on the basis of what the salespeople told them,'' said Joseph Mason, a finance professor at Louisiana State University in Baton Rouge who follows securities markets. ``As long as everything keeps chugging along that is fine, but when the market turns, we're done.''

Massachusetts, part of the task force, charged UBS with fraud today for its sales of auction-rate securities to investors in the state, Secretary of State William Galvin said. The complaint alleges UBS told investors the long-term bonds were ``safe, liquid cash alternatives'' when the bank knew the securities weren't.

`A Lot of Doughnuts'

``They were selling me their junk student-loan bonds, knowing the market was going down,'' said Jimmy Walker, 53, who owns a doughnut business in Dallas and who bought $1 million of auction-rate securities on Jan. 23 from Bank of America Corp.

He says his banker brought in a broker who recommended the securities and never mentioned anything about auctions. ``It took a lot of doughnuts to get $1 million in the bank,'' Walker said. ``That's my life savings. I'll be dead by the time I collect.''

Bank of America spokesman Matt Card said the bank doesn't discuss individual cases. The Charlotte, North Carolina-based bank, like other firms, has offered loans to clients stuck in the securities who need money immediately.

``The global credit markets have been going through an unprecedented period of dislocation,'' Card said. ``This has affected firms, including Bank of America. The market for auction-rate securities has changed dramatically.''

Supported by Banks

Auction-rate bonds, invented about two decades ago, allowed local governments, hospitals and universities to borrow money for the long term at cheaper, short-term rates by reselling the debt at auctions held every seven, 28 or 35 days. Until mid-February, banks supported prices by bidding for bonds that went unsold.

Once the banks stopped buying, rates soared as high as 20 percent because the failed auctions triggered a penalty rate for issuers.

In several cases, that rate was only set in recent months, as banks recognized demand was fading and asked issuers to waive limits on how much interest they would pay if the auctions failed, according to the interviews and documents.

In November the Illinois Student Assistance Commission approved raising the penalty interest on its $880 million of auction-rate debt on the advice of Zurich-based UBS, said executive director Andrew Davis.

First Failure

UBS had been telling officials for several months that investors wanted to be paid more interest to own the Springfield, Illinois-based student lender's auction-rate bonds, Davis said.

``No one wanted to be the first guy to have an auction fail,'' Davis said. ``The thinking was if we paid that much more interest there would be demand, and it would give the market time to heal itself.''

Some securities filings didn't disclose the new penalty rates and their implications of turmoil in the market until March, after buyers like Walker and Cui purchased auction-rate debt recommended by their brokers.

In Cui's case, she says her broker recommended bonds issued by the Pennsylvania Higher Education Assistance Agency, the Missouri Higher Education Loan Authority, the New Hampshire Higher Education Loan Corp. and similar agencies. UBS and New York-based Citigroup, which ran auctions for the Missouri and New Hampshire authorities, sought waivers from the student-loan lenders on how high the rates on the bonds could go in case demand was insufficient.

Avoiding Failures

At the insistence of UBS, Missouri Higher Education agreed on Dec. 14 to pay higher rates on $3.21 billion of auction debt if bidding wasn't successful, according to disclosure documents posted in March. The authority made the change ``in an attempt to avoid having `failed auctions,''' the documents said. Will Shaffner, a spokesman for the Missouri lender, didn't return calls seeking comment.

New Hampshire Higher Education also disclosed in March that it changed its bond documents as of December to pay a higher penalty rate in the event of a failed auction. The change resulted in rates as high as 18 percent, the filing says.

The nonprofit lender said it changed the document at the request of UBS ``to respond to disruptions in the auction-rate securities market.'' New Hampshire Higher Education spokeswoman Tara Payne declined to comment, referring questions to its Web site and to UBS.

Liquidity Breakdown

Karina Byrne, a spokeswoman for UBS, declined to discuss individual cases, saying the firm is ``committed to addressing our clients' concerns about the market events that caused the breakdown of liquidity for auction-rate securities.'' UBS is offering investors stuck in the securities loans of as much as 100 percent of their par value.

That value is diminishing, according to UBS, which said in March it was cutting the estimated value of auction-rate securities held by its customers by 5 percent to reflect the lack of trading.

A close reader of bond documents might have learned about the potential failures.

Pennsylvania Higher Education said in a Sept. 30 quarterly report that as early as August ``disruptions in the capital market related to subprime mortgages began affecting the pricing of the auction-rate debt securities financing our portfolio of student loans.''

A settlement with the SEC in May 2006 over auction-rate securities sales practices required dealers to disclose risks to investors. A description of those practices can be found on most dealers' Web sites.

Corzine's View

While investors may have believed the securities were liquid, ``I don't know why they really did think that because they had a maturity on them,'' New Jersey Governor Jon Corzine said in an interview. The state is refinancing as much as $375 million of its own auction-rate debt. Investors' confusion ``may be how they were sold,'' Corzine, a former bond trader and head of Goldman, Sachs & Co., said.

That is the argument made by Aaron Friedman, 51, a computer programmer from Delray Beach, Florida. He said he bought $175,000 of auction-rate preferred shares from Citigroup on Jan. 29. On Feb. 11, two days before hundreds of auctions began failing, Friedman said his broker at Citigroup told him ``he had a lot more available.''

Friedman said he refused to buy more after getting a document confirming his earlier purchase that listed a Web site where he could learn about Citigroup's auction-rate procedures. That was the first time Friedman said he had heard the word ``auction'' used to describe his investment.

`Conflict of Interest'

``At that point I didn't want to any more,'' said Friedman, who has hired the law firm of Williams Kherkher Hart Boundas LLP in Houston to bring a lawsuit.

Steven Sapirstein, the manager of the Boca Raton, Florida, branch where Friedman opened his account, declined to comment. Bruce Glassberg, who was handling Friedman's case in Citigroup's early dispute-resolution group in New York, referred questions to Citigroup's public relations department. Citigroup spokeswoman Danielle Romero-Apsilos said the bank wouldn't comment.

Harry Newton, 66, a New York City investor with $3.5 million of auction-rate securities, said telling borrowers that cracks in the market were developing and leaving investors in the dark ``pointed up the immorality on Wall Street.''

``Most of them knew that auction-rate securities had problems and they didn't tell anyone,'' said Newton, who runs the AuctionRatePreferreds.org blog.

Also suffering is Richard Stahl, 73, a retired car dealer in Hollis, New Hampshire, who said he bought $650,000 of auction- rate bonds on Jan. 10 issued by New Hampshire Higher Education from his UBS broker, Christian Parker in Boston.

A month later Stahl learned he couldn't sell the debt. Stahl says he was never told about the change the authority made to the bond documents or that he was investing in the auction-rate market. Parker declined to comment.

``This is a definite conflict of interest,'' Stahl said. ``On the one side they're my financial adviser, and on the other side they're the underwriter and the auction manager.''

To contact the reporter on this story: Darrell Preston in Dallas at dpreston@bloomberg.net; Michael McDonald in Boston at Mmcdonald10@bloomberg.net.

Last Updated: June 26, 2008 10:42 EDT