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“This is the right thing to do,” said Michelle Creeden, a UBS spokeswoman, in a prepared statement. “It is in the best interest of our clients to provide them full transparency regarding their account. Given current market dislocations, this is the next logical step for any committed wealth manager.”

UBS will inform clients of the reduced value of their holdings via their online statements, Briefing.com said, citing a Dow Jones report. UBS customers had maintained full value without any discount that could reflect bondholders’ inability to sell their holdings.

UBS’s action comes after auction-rate bond failures rose to about 71 percent this week, up from about 69 percent last week, according to data compiled by Bloomberg. The $330 billion auction-rate securities market originally attracted borrowers by offering financing for 20 years or more at variable costs determined through periodic bidding.

Auction-rate bonds have interest rates determined through bidding run by dealers every seven, 28 or 35 days. When there aren’t enough buyers, the auction fails and rates are set at a predetermined level set in documents when the bonds were issued.

“The fact that they aren’t worth par or may not be worth par is not going to be acceptable to any owners of these securities,” said Gary Miller, a partner at the Houston law firm of Boyar and Miller. “It’s certainly not acceptable to me.”

Couldn’t Cash Out

Miller invested $750,000 from the sale of his house in auction-rate securities with UBS last December. After signing a contract on a new home, Miller said he called his broker to cash out of the securities and was told he couldn’t. When he bought the debt, Miller said he asked his broker whether there had ever been an unsuccessful auction.

Until now, customers who were unable to sell securities in regularly scheduled auctions were told that the securities retained full value and would receive higher interest rates.

UBS, however, using an internal model to value the securities, will mark them down Friday and inform clients via their online statements. The markdowns will range from a few percentage points to more than 20.

“This is the right thing to do,” said Martin Hoekstra, head of wealth management at UBS. “It doesn’t make sense to delay the pain. As a principal, we think we should tell clients what their securities are worth, and if it’s an illiquid market, estimate what they are worth.”

The losses won’t be realized immediately, as investors can’t sell the securities for lack of a market. But the unilateral move is sure to roil relations between brokers and their clients, who generally believed they were buying investments that were a safe alternative to cash offering a slightly higher yield.

UBS wouldn’t disclose the total value of auction-rate securities held by its clients, but Hoekstra said it was “a reasonable amount” concentrated among wealthier clients. The banks U.S. wealth management unit oversaw about $920 billion in client assets at the end of 2007.

The brokerage industry has used auction-rate securities as cash alternatives for nearly two decades. More than $300 billion of the securities are held by investors ranging from mutual funds and corporations to wealthy individual investors, according to Moody’s Investors Service. The securities are long-term bonds sold by issuers such as municipalities, arts organizations, universities and closed-end mutual funds like Nuveen Investments and BlackRock with interest rates reset in auctions held every 7 to 35 days.

The auctions are failing, because banks such as UBS, Goldman Sachs Group, Merrill Lynch, Citigroup Inc. and Wachovia Corp. that often conduct more than 100 auctions a day have balked at buying the securities when there aren’t enough bidders.

The Swiss bank told clients it was reducing the value of auction-rate securities in their accounts, by an average amount of 5%. It also refused to buy the bonds back from investors who bought the securities, thinking they were getting an easy-to-sell, higher-yielding alternative to money market funds but instead found themselves stuck with illiquid securities and capital losses, courtesy of the global credit crunch that began in the U.S. subprime mortgage market.

“This is the right thing to do,” said a UBS (nyse: UBS – news – people ) spokeswoman. “This is in the best interest in our clients regarding our accounts. Given the current market dislocation this the next logical step for any committed wealth manager.”

Auction-rate securities are long-term bonds issued by local governments, agencies, or corporations but sold in periodic auctions, say every 7 to 28 days, to set the interest rate. Firms that handle the auctions, like UBS and most of the big Wall Street concerns, used to step in an buy in the auctions if there weren’t enough bidders.

But that all went by the wayside in January and February as investors fled the bond markets. Auctions failed after no buyers showed up and the banks refused to step in as they had previously done. That meant the auctions failed, leaving brokerage customers holding the bag and issuers paying much higher penalty interest rates. The Port Authority of New York and New Jersey, for example, saw its rate skyrocket to 20% from 4% when its auction failed in February.

As a consequence of paying soaring penalty rates, many issuers are converting their auction rate bonds to fixed-rate bonds, putting more pressure on the remaining auction-rate securities that still haven’t started selling again. The bonds cost more than the issuers were paying on the auction-rate securities but yield far less than the penalty rates.

The banks backed off supporting the auctions because they didn’t want to risk taking more illiquid assets on their books after collectively writing off more than $100 billion in mortgage and credit derivatives. UBS has been among the hardest hit of the banks, already writing down $17 billion worth of credit holdings and facing another $11 billion in write-downs in the first quarter, according to analysts at Oppenheimer.

Its problems don’t stop there. Massachusetts securities regulators subpoenaed UBS, Merrill Lynch and Bank of America about their sale of auction -ate securities to customers, particularly bonds sold in closed-end mutual funds. The state is looking at what the banks disclosed about the possible risks of the securities.

“We received calls from a young saver whose house down payment is now frozen; two siblings whose family trust is now frozen; and small business owners who find their business interrupted because money they thought was liquid is tied up in these frozen securities,” said William Galvin, the Massachusetts secretary of the commonwealth, in a statement.

UBS wouldn’t say how much its brokerage customers own in auction rate securities, but the market is about $330 billion. The timing of UBS’s decision is perhaps telling. American investors are facing tax time, when many will need access to cash to pay Uncle Sam.

The Swiss banking giant previously told customers who were unable to sell the securities in scheduled auctions that the bonds would retain their full value and receive enhanced interest rates, according to TradeTheNews.com.

After falling 2.4% in Switzerland, to 28.98 Swiss francs, before the announcement, UBS American depositary receipts slid further in New York, dropping to $27.80, a loss of $1.33, or 4.6%, on the day. Less than a year ago, the stock had been above $66.