(originally published on February 16, 2008)
Another shoe dropped this week in this saga with the state of Michigan suspending a major student-loan program led by the sudden collapse of the estimated $300 billion auction-rate securities market. Auction-rate securities are another one of those complicated securities that seemed to offer something in return for nothing. They are long-term securities that unusually behave like short-term bonds. The securities purportedly offered borrowers, typically tax-exempt local governmental or quasi-governmental authorities – a school district, hospital district or a municipality – a method to borrow long term without paying the relatively higher interest rates that investors usually demand to lend long term. This was achieved by the covenants of the bond that required securities to be auctioned every 7, 28 or 35 days. Investors (typically short term money market funds) did not mind this at all because they got an asset that seemed as good as cash – investors wanting to cash out their bonds could sell it back to the investment banks who subsequently sold it to newer investors – and yielded higher than bank deposits.
Because the borrowers bought insurance from mono-line insurance companies that then imparted an investment grade rating to the bonds, investors simply looked at the rating and made their decision. In theory, the market was always running the risk of auctions failing for lack of enough willing buyers... but that possibility seemed very remote. Issuers also ran the risk of invoking the covenant penalty clause that compensated the buyer for the lack of liquidity – if an auction failed, the interest rate that the borrower had to pay jumped up. But since the possibility of the market failing seemed so remote, borrowers continued to pile on the market.
Circa credit crunch 2007. What seemed remote is now reality. With the sub-prime genie out of the box, the creditworthiness of mono-lines is in serious doubt. Ambac, MBIA, FGIC and other mono-lines have been downgraded by rating agencies and face an imminent danger of having their ratings cut. A rating cut would be akin to a death knell for these mono-lines. Without their ratings, they would have nothing left to sell.
Also, it is a big big problem for those who bought into those ratings. With not enough buyers to take all the paper that was insured by these mono-liners, markets are failing. Investment banks are being forced to take that paper that they helped to sell. Investors' confidence in the financial order seems shaken. Investors no longer trust assurances given to them, having already witnessed what happened to those naïve enough to believe that their sub-prime filled toxic waste was safe. A loss of faith and confidence can quickly become a self-fulfilling prophecy. New investors will refrain from parking their money in these auction-rate securities knowing very well that they are not as good as cash, making these securities appear to be even worse investments.
In the last few weeks, a series of auctions have failed, leaving investors stuck with illiquid securities and borrowers facing hefty penalty rates. Fathom this. The Port Authority of New Jersey, which had a failed auction of $100 million last week, saw their interest rates leap from around 4% to 20%! Quick back of the envelope math... that's an extra $300,000 per week. The collapse of this market does not reflect any new problem with the borrowers; the Port Authority is as financial sound today as it was a fortnight ago. Instead this reflects the latest shoe to drop in the broader credit contagion. There are many other bonds from solid issuers that are quoting at over a 10-15% yield, up from 4-5% just a few days ago. Less than 1% of tax-exempt bonds actually default. Most of these are good-quality issuers (some even sovereign), yet the interest rates are higher than CCC junk bonds.
This has obviously put pressure on politicians to act. Eliot Spitzer, the Governor of New York, threatened mono-lines this week, giving them three to five days to find sufficient capital to resolve the crisis. Or else the state steps in and takes charge. It is in this context that Warren Buffett's offer to take over $800 billion worth of municipal bonds from the mono-lines seems like a masterstroke.
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