Auction-Rate Danger Flagged in '05

"In order for these securities to be considered cash, they had to ensure the auctions were done in an upfront manner," says Pan, who made the same point in a 2006 note to clients.

Meanwhile, Wall Street by and large continued to offer the products to investors as a safe, better-yielding alternative to cash.

Wake Up the Watchdogs

The Financial Industry Regulatory Authority, the financial industry's self-policing organization, did not say much about auction-rate securities being labeled as cash until Regulatory Notice 8-08 issued in March 2008 -- after the auction-rate market had already failed.

"In light of the recent events in the marketplace, member firms should give careful consideration to the classification of these securities on customer statements as cash or cash equivalents," the notice read.

Nancy Condon of FINRA said the group has rules about the frequency of contact to clients, but no rules on how to characterize products. Then in April 2008, FINRA suggested investors read the offering documents on investments and said investors could file a complaint on the organization's Web site.

The SEC, while front and center in the Citi and UBS settlements and other ongoing auction-rate investigations, did not appear outwardly active in scrutinizing the auction-rate market prior to the onset of problems.

"The SEC is always the bridesmaid," Pan says. "They are never at the front of these enforcement actions."

Pan pointed out that the investment banks could have saved themselves from the problems they are now facing. Their objective was to make sure the auctions didn't fail, but they missed the big picture. The big risk they identified was the failure of the auctions, which most assumed would never happen. The unthinkable began happening in September 2007.