By Joseph A. Giannone

State investigators previously disclosed their interest in looking into how Fidelity and other brokerages sold auction rate debt -- investments long marketed as cash alternatives that have been nearly impossible to sell for most of this year.

More recently, Cuomo's staff began taking a close look at whether Fidelity marketed Goldman-underwritten ARS because it received other services from the world's largest investment bank and therefore had an incentive to sell auction-rates to clients, the sources said.

The state began focusing on the relationship after finding that most of the ARS sold by Fidelity were underwritten by Goldman, the sources said.

Goldman was the No. 5 underwriter of auction-rate municipal bonds since 2000, according to Thomson Reuters data.

Goldman and Cuomo's office declined to comment.

Fidelity spokeswoman Anne Crowley said Fidelity received no special financial incentive to sell auction rate securities. Roughly 600 Fidelity customers who bought ARS before February 2008, when the markets collapsed, still hold them.

The bulk of Fidelity's discount brokerage clients are self- directed, although it has a small wealth management business for richer households.

Closely held Fidelity has said it does not issue or market auction-rates. Like other "downstream" brokerages, it argues the banks that issued these securities should repurchase them from investors no matter where they have their accounts.

NOT CONVINCED

Cuomo's office last week expressed skepticism that downstream brokers were unaware of the weakness of auction rate markets and the possibility they could collapse.

"Our investigation will closely examine whether Fidelity or any other downstream brokerages consciously avoided knowledge of the ARS market deterioration," Benjamin Lawsky, special assistant to Cuomo, wrote in a letter to regional bond dealers last week.

He also noted "some evidence indicates that Fidelity was actively marketing auction rate securities to its high net worth clients."

New York, together with the Securities and Exchange Commission and Massachusetts and other state securities regulators have announced settlements in recent weeks with eight of the largest banks and brokerages. The firms will buy back about $50 billion of these illiquid securities from their own retail clients and pay more than $500 million in fines.

State and U.S. regulators currently are focused on smaller brokerages, including Fidelity, as they work down the list of some 30 to 40 firms that participated in these markets.

Auction rates are long-dated municipal, student-loan or mutual fund debt that paid interest rates that reset periodically in auctions. These auctions also provided investors with the opportunity to cash out.

Yet the auctions, which struggled last year amid the credit crunch, failed by January as banks stopped taking up the remaining supply. More than a hundred thousand investors were stuck holding the debt and they complained their brokers misled them about how risky these securities were.

(Additional reporting by Svea Herbst-Bayliss in Boston and Saumyadeb Chakrabarty in Bangalore; Editing by Erica Billingham)