Sunday, February 24, 2008

Auction Rate Securities: the Credit Crunch Hits Main Street

Until recently, the credit crunch largely manifested itself on Wall Street. Banks would be unable to get overnight loans, mortgage lenders would careen towards bankruptcy court, SIVs and conduits--financial creatures of the night that saw the light of day for the first time last summer--would need bank bailouts, and leveraged buyouts of corporations would end up being indefinitely financed by banks that didn't want to be long term investors. People who were trying to buy a house, or to refinance a house, felt the cold wind of the credit crunch. But most Americans weren't trying to buy or refinance a house, and they could concentrate on the World Series and the BCS.

Now, the arcane and obscure from the world of finance, in the form of auction rate securities, have emerged from the swamp to terrify the good citizens of Middletown, U.S.A. To understand auction rate securities, let's take a brief look at corporate finance.

AAA rated corporations can get low cost financing in the commercial paper market. Commercial paper is short term unsecured debt (less than a year in maturity, and sometimes just a week or two) issued by AAA rated corporations. Institutional investors and some wealthy individuals invest in commercial paper. It's often purchased by money market funds. Corporations use commercial paper to finance long term needs, which means that the paper becomes part of an issuing corporation's permanent capital structure. Because short term interest rates are low, compared to the long term returns corporations project from their investment of the funds, borrowing in the commercial paper market can be highly profitable.

However, the short term nature of commercial paper means the issuing corporation must go to the money markets often to roll over maturing paper. When it can't find new investors, the ship hits the sand. That's what happened to some mortgage lenders and SIVs last year. When there is a credit crunch and purchasers for new commercial paper vamoose, the long term nature of the investments made with the borrowed monies makes it difficult to raise funds from asset sales to pay off maturing commercial paper. So the issuers needed bailouts or capital infusions.

Other borrowers wanted access to the low cost financing of the commercial paper market. Among them were muncipalities, other governmental authorities, medical facilities, student loan lenders and nonprofit institutions. Although many of them could borrow long term in the tax exempt markets at favorable rates, short term tax exempt rates are even more favorable much of the time.

The financial engineers on Wall Street saw an opportunity. About twenty years ago, they developed the concept of auction rate securities, which purport to provide long term financing for a variety of non-AAA rate borrowers at short term rates. Sales people like to call this a "win-win" situation. Realists would describe it as hoping to eat your lunch and have it, too.

With auction rate securities, borrowers get a long term arrangement that employs an auction mechanism for re-setting the interest rate at short term intervals, like a day, a week, a month or a few months. At each auction, current holders of the auction rate securities can put them up for sale and new investors (and current holders) can bid to buy them. In this respect, the auction rate securities are little different from commercial paper. If the auction process works as intended, investors get a short term investment they can buy or sell quickly, and the borrower gets long term capital at short term rates.

A problem is that borrowers in this market usually aren't AAA rated. By themselves, they might not be able to attract the auction bids needed to make the process work. In order to gussy them up, underwriters arranged for bond insurance companies to insure auction rate securities. The bond insurers have generally carried AAA ratings. Thus, a guarantee from an AAA rated insurer dolled up the auction rate securities enough to make the auction process work.

Then, a funny thing happened on the way to the forum. The bond insurers began galavanting with CDOs and other denizens of the structured finance markets. These securities were the hotties of the financial markets in recent years. But they turned to be complex, and to have some flaws. Their relationship with the bond insurers went sour as the mortgage crisis emerged. But breaking off the relationship has proven extremely difficult. With a spouse, you can send an e-mail asking for a divorce. With a financial guarantee, though, investors, underwriters, regulators and even a governor might enter the picture.

Because the bond insurers have become imperiled by the mortgage crisis, the auction rate securities they guaranteed have come into question. Even though some major bond insurers haven't lost their AAA ratings, the flow of credit to auction rate borrowers has crunched as auctions have failed. Although the banks that underwrote some auction rate issues provided a degree of support for a while, they now shy away from further aid. The extent of the failed auctions now appears to be around $80 billion and rising (out of a total of around $300 billion in auction rate securities). The banks won't take this bullet for investors.

Many auction rate borrowers are looking for alternative sources of funds to pay off the securities that couldn't be sold at auction. Investors holding those securities are usually getting a higher rate of interest (as a penalty on the issuer for the failed auction). But their holdings can be illiquid, and a bump up in interest rates may be little consolation for loss of access to their capital.

A lot of people in prominent government and private sector positions are now scrambling to shore up the bond insurers. Whether or not their efforts bolster auction rate securities will depend heavily on the terms of whatever bailouts and capital infusions are arranged. Regardless of what is, or is not, accomplished, auction rate securities are an example of how the financial engineers on Wall Street tried to make a higher risk borrower appear to be lower risk, and got too clever by half. There evidently wasn't a Plan B in case the bond insurers lost their AAA ratings, and that rating was the linchpin of the auction process. Maybe there was disclosure to investors about the potential problems if the bond insurer lost its AAA rating. But the consequences to investors don't comprise the entire picture.

There may be significant public consequences from this failure of another Wall Street financial engineering project. As borrowing costs rise for auction rate issuers, public budgets will be tightened up, employees could be laid off, pay raises, bonuses and benefits might be curtailed, and programs may be cut. It's one thing to say caveat emptor to the institutional investors and wealthy individuals who hold these puppies, or to the municipalities and other organizations that issued them. But for the middle and lower income people who now lose pay increases, bonuses, benefits, access to needed public services, or even their jobs, the credit crunch has become a recession or even a depression.

Prominent federal officials continue to issue concerned sounding press releases meant to assure us. But they talk mostly about bandages and emergency back-of-the-envelope measures that would do little or nothing to prevent these kinds of problems from happening again. Preventative measures would require increased regulation, a heresy of the first order in Washington and New York. But to the citizens of Middletown, some change might seem in order.

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