Some of Wall Street's biggest financial institutions are bracing themselves for large fines and legal settlements over the collapsed auction-rate securities market, which is shaping up to be one of the costliest mis-selling scandals of the credit crisis to date.

Thousands of individuals, and many more institutional investors, have been left holding bonds that they cannot sell, despite being told that these investments were the equivalent of cash.

An auction-rate security is a bond whose interest rate is not fixed, but set at a weekly or monthly auction, when existing holders can sell the bonds. For more than 20 years, Wall Street banks acted as "market-makers", stepping in to buy the bonds at auction if demand was weak, so that holders could cash out. But amid the spiralling credit crisis, they stopped acting as buyers of last resort and since then almost 60 per cent of auctions have failed.

Banks created, ran and then ultimately abandoned the auction-rate market, said Jonathan Levine, attorney at Girard Gibbs in San Francisco, one of several law firms launching class action suits against the biggest players.

"We think this is one of the biggest frauds on Wall Street in years," he said. "There is a perception that this is just a temporary liquidity problem for a few rich people, but that is not true. Brokers were selling this stuff to anyone who walked in the door with $25,000 (£12,800), to people who had sold a house and not yet bought a new one, to people who had come into a small inheritance. People can't retire, small business owners cannot pay payrolls, it is affecting people's lives."

Those stories are set to give the auction-rate securities issue a particularly human face as regulators pick through the myriad scandals and market failures revealed by the credit crisis. Wall Street made about $825m a year in fees from handling the regular auctions, on top of a total of $1bn from underwriting the issuance of the bonds in the first place.

While one arm of a firm was underwriting the bond, another would be selling the bonds to their brokerage clients. Lawyers say that the success of class action suits and regulatory enforcement actions will hinge on what individuals knew about the securities their brokers sold them; the industry says risks were disclosed.

Bruce Coughlin, a New Yorker, who discovered his mother had 60 per cent of her savings in $100,000 of auction-rate securities when she died earlier this year, says she told him the cash was in an easy-to-sell money market fund.

"We found out when we called the broker at Smith Barney and wanted to sell the securities," he said. "The fund is actually listed on their account breakdown as a 'long-term' investment. I pressed him: 'So you mean you sold a 76-year-old woman a fund that would be impossible for her to get out of?' Just how long a long-term horizon did he expect her to have?"

A spokesman for Citigroup, which owns Smith Barney, said the company would not comment on individual cases or on pending litigation and legal investigations, but he added that Smith Barney's brokers were "working on liquidity solutions for clients and offering them the ability to borrow against their positions". The same line is being taken by the other big brokerage firms.

Regulators, though, are already circling. New York Attorney General, Andrew Cuomo, has issued subpoenas to at least 18 banks, including Merrill Lynch, UBS and JPMorgan Chase. Wach-ovia said last week that it had been subpoenaed or received requests for information from the Securities and Exchange Commission and state regulators. Citigroup is also understood to be helping authorities with their investigations.

www.independent.co.uk