A number of corporations bought auction rate securities with their excess cash. They believed that since the instruments offered better yield than many market funds, they would be good for balance sheet management. They also thought that since auction-rate paper had been liquid and widely traded since 1985 that moving in and out of the market would be easy.

It was easy until it wasn't.

The investment banks and money center banks which made the market in these instruments pulled out at the beginning of the credit crisis. They did not want to keep risking their own capital to buy the paper and hold it to keep the market trading. Traditionally what was not bought at one auction was picked up by banks and held until the next round of trading. In essence, large financial firms kept the market trading by underwriting the system in exchange for large commissions.

The New York Times reports that Massachusetts secretary William Galvin has subpoenaed some revealing e-mails from UBS AG (NYSE: UBS) that illustrate its decision to stick retail investors with its worthless ARS inventory.

I've been following the $330 billion ARS market since February when the weekly auction market for resetting their yields seized up. Since then 4,852 comments have been posted from individual investors whose money is frozen in ARS limbo.

The e-mails reveal that UBS's corporate customers did not want to buy the ARS on UBS's books. So UBS tried to unload the worthless securities onto its individual customers. Absent dumping the ARS, UBS would need to take the hit itself. Rather than do that, UBS decided to let those foolish enough to fall for the ARS sales pitch to take the losses. The Times illustrates this decision clearly in an e-mail from Joe Gallichio, a managing director in the municipal finance department at UBS, on February 21, after the ARS market had frozen.

The list of companies slapped by the auction rate securities debacle continues to grow. This morning, Lakes Entertainment (NASDAQ: LACO) issued a press release announcing an agreement with UBS AG (NYSE: UBS) that's worth quoting verbatim:

... effective April 11, 2008, it entered into a client agreement with UBS Financial Services ... for the purpose of borrowing and/or obtaining credit in a principal amount not to exceed $11.0 million ("Margin Account Agreement"). The Margin Account Agreement is secured by Lakes' auction rate securities ("ARS") held at UBS ... As previously announced, the types of ARS investments that the Company owns are backed by student loans, the majority of which are guaranteed by the U.S. government and all of which have credit ratings of AAA or Aaa. Historically, these ARS investments have been highly liquid, using an auction process that resets the applicable interest rate at predetermined intervals, typically every 28 days, to provide liquidity at par. However, as a result of the recent liquidity issues experienced in the global credit and capital markets, the auctions for all of the Company's ARS investments failed beginning in February 2008 when sell orders exceeded buy orders.

No 8-K detailing the terms of the margin account agreement has yet been released, so we don't know what interest rate they're paying for the credit. But it may be higher than the yield on the auction rate securities that UBS sold to them.

Here's what makes this situation a mess. UBS was recently subpoenaed by New York Attorney General Andrew Cuomo, seeking information about whether the firm misled investors in auction rate securities into believing that the investments were cash-like and more liquid than they have turned out to be.

Now that these companies don't have access to the cash they thought wouldn't be a problem to get at, UBS is helping them out: by letting them use the ARS as collateral to borrow from the bank that got them into this mess: presumably, with interest.

Imagine you take your hard earned money and at the urging of your broker put it into an account that pays just a bit more than a typical money market fund. Your broker assures you that the account would offer a higher return and would offer liquidity at weekly auctions. Sounds good, no?

Now imagine that you wake up one morning and find that money frozen -- as in you thought you had easy access to your money and now you can't get a penny of it. As I posted last month, that's what happened to investors in Auction Rate Securities (ARS) -- a $330 billion market. Since that post, there have been 583 comments from people who have been affected by this mess.

One commenter, Dave Lehrian, needs to pay taxes on a business he sold. He moved the entire proceeds from selling his business from a bank account at Wells Fargo & Co. (NYSE: WFC) into an ARS. Now he still owes $350,000 in taxes on the sale but can't get his money out of the ARS account to pay them. I can only imagine the frustration he must feel. Here, in his own words, is his story:

The Wall Street Journal [subscription required] reports that we need to learn about another acronym thanks to Wall Street's financial engineers whose fragile financial instruments keep blowing up. Today's explosion is in variable-rate demand notes (VRDN) -- which let issuers borrow for long periods -- but at short-term interest rates. Like auction-rate securities (ARSs), interest payments adjust on a weekly or even daily basis. The difference is that securities firms sell VRDNs at whatever interest rate meets the market's demand.

This is a huge market -- $500 billion, or 52% bigger than the $330 billion ARS market. I've been asked what I thought the next shoe to drop would be after the ARS blowup. And I'm happy to report that I said I had no idea. I had never heard of VRDNs before this morning. But the market for VRDNs is freezing up -- just like the ARS market.

Specifically, some VRDN auctions failed -- hitting some municipalities with sharply higher interest because dealers of the debt are having trouble selling it. Last week, rates on $300 million of California's variable-rate demand notes rose to 8.25% from 2% the previous week. As with the ARS market, this freeze up will lead to more unpleasant surprises for holders of VRDNs -- like the one I posted on yesterday in which a journalist who thought his ARS investment was as liquid as a money market fund discovered his funds were frozen.

The worst part for the investing public is that we have no way of knowing where the next explosion will take place. It looks like some financial terrorists are winning.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

As I posted last week, Auction rate securities (ARSs) is a $330 billion market for long-term bonds that are supposed to pay lower rates because their interest rates are set through auctions. Municipalities who issued ARSs are suffering because 1,000 of these auctions failed and instead of paying 3% interest rates, they have to pay 20%. And if that wasn't bad enough, the investment banks that oversee these auctions are refusing to let investors withdraw their money.

DealBreaker explains that the demand for ARSs dried up sometime last year, and evaporated completely in 2008. This shift was driven by a March 2007 decision by the Financial Accounting Standards Board (FASB) that the heading "cash equivalents" should be eliminated from balance sheets and cash-flow statements. The FASB recommended that cash-flow statements should present only flow related to cash. Items currently classified as cash equivalents would be classified in the same way as other short-term investments.

Corporations responded to this by moving out of the ARSs so that their balance sheet cash positions would not be reduced as a result of the FASB decision. This meant that many corporations no longer wanted to buy ARSs. As corporate demand for ARSs vanished, banks had to keep more ARS inventory onto their own books. Since banks need to maintain a constant ratio of capital to assets, they needed to increase their capital commitment at the same time the banks faced challenges from other parts of the credit markets -- such as Collateralized Debt Obligations (CDOs). Last week they decided against committing additional capital to supporting the auction, and let them fail.

It seems as though every week, the public is forced to learn another one of Wall Street's strange names for a surefire deal that couldn't miss. But the reason we're learning about those strange names is because -- contrary to promises -- the can't miss deals are shutting down -- taking Wall Street's credibility down along with them.

The latest of these is auction rate securities (ARSs) -- a $330 billion market for long-term bonds that are supposed to pay lower rates because their interest rates are set through auctions. The New York Times reports that municipalities who issued ARSs are suffering because 1,000 of these auctions failed and instead of paying 3% interest rates, they have to pay 20%. And if that wasn't bad enough, the investment banks that oversee these auctions are refusing to let investors withdraw their money.

Which investment banks are imposing this pain? Goldman Sachs Group (NYSE: GS), Merrill Lynch (NYSE: MER), and Lehman Brothers Holdings (NYSE: LEH) and the problem with ARSs is not limited to municipalities entities such as the Port Authority of New York and New Jersey. Closed-end mutual funds, student loan companies and corporations also issue them.