UBS-NY accord offers 'first aid' to muni issuers

CHICAGO/NEW YORK (Reuters) - New York's auction rate settlement with UBS AG (UBSN.VX)(UBS.N) includes the first recovery of money for the state's issuers who sold this debt and hired the giant Swiss bank as their underwriter, according to terms of the deal unveiled on Friday.

Until now, the few settlements between banks and regulators have almost entirely focused on aiding investors who bought these securities, thinking they were nearly as safe as cash, only to get trapped with debt that could not be sold when the $330 billion market froze in January.

The fee recovery provision New York's Attorney General Andrew Cuomo won in the UBS settlement likely will be matched by other states with similar investigations, predicted Evan Rourke, a muni strategist with M.D. Sass in New York.

At least 12 states are probing whether banks and brokers misled investors in auction rate paper, which is long-term debt whose rates are periodically reset at auctions.

States, cities, schools, hospitals and museums all sold this tax-free debt, which saved them money because they captured lower short-term rates. But when the market for auction rate debt collapsed, many issuers were briefly forced to pay punishingly high interest rates, in some cases up to 20 percent.

"I think that naturally any state that sees what New York state is getting and will have to spend money to refinance will do the same thing. They will press for the same treatment," Rourke said. "It's hard for banks not to do the same thing."

After all, Merrill Lynch MER.N on Thursday announced it would buy back auction rate securities from its retail clients, who hold about $12 billion of this debt after Citigroup (C.N) said that it would repurchase more than $7 billion of its investors' auction rate paper.

Though Citi also settled probes by New York and the U.S. Securities and Exchange Commission, New York and Massachusetts both warned Merrill their investigations are ongoing.

FEE! FI! FO! FUM!

Financial analysts have estimated that muni issuers have refinanced about half of the outstanding auction rate paper, and sparing them extra fees could speed this process.

Some issuers have cited the high cost of restructuring this debt as a major impediment. Underwriting can be quite lucrative for banks, many of which might prefer not to give up this income when their profits are plunging with subprimes.

New York's fee recovery provision with UBS does not appear to be an overwhelming expense, at least not yet, though this cost could grow if other states follow suit.

Only a tiny universe of New York auction rate deals fit the time frame of the UBS settlement -- the debt must have been issued since August 1, 2007, which is the same month that spawned the global credit crunch.

For example, UBS helped underwrite a New York City Municipal Water Finance Authority offering that had $97 million of auction-rate debt, $78 million of this debt for New York City, and $350 million for the Port Authority of New York and New Jersey, according to Thomson Reuters data.

Cuomo might try to wrest a fee recovery provision from other banks.

New York state issuers have restructured $1.6 billion of auction rate paper, the state's budget office said.

UBS was not on the list of underwriters distributed by the state budget office. That roster included Citigroup, Merrill Lynch and Goldman Sachs (GS.N). In April, Goldman said regulators asked it for information about auction rate debt.

JPMorgan (JPM.N), one of many banks named as a defendant in an auction rate lawsuit filed by the City of Los Angeles, also appeared on that list of underwriters. So did Morgan Stanley (MS.N), which is repaying two Massachusetts cities for auction rate investments.

(Additional reporting by Jason Szep in Boston and Grant McCool in New York)

(Reporting by Karen Pierog in Chicago and Joan Gralla in New York; Editing by Jan Paschal)