I don�t know how Broadway sells tickets these days when
folly is in so plain array on Wall Street. Auction-rate securities drama
provides the latest tale of greed and betrayal.
Investors are stuck with big losses, because investment
banks miscalculated their own risks and are putting it to their clients, again.
Municipalities and public agencies, like the New York
Dormitory Authority, require long-term financing for big projects.
As we learn in Economics 101, the yield curve slopes up.
Governments and businesses generally pay higher rates on 30-year bonds than
30-day notes, in part owing to the possibility that interest rates on new bonds
may rise in the future.
When interest rates go up, existing bonds become worth less
than their original sale value and their owners take a loss. What we call
interest rate risk.
Public agencies as well as others needing long-term cash
would like to get long-term money at short-term rates. This is like an opera
lover seeking box seats for balcony prices.
Conversely, investors would like to lend money only for the
short-term but get those higher long-term rates. The opera company selling
balcony seats at box prices.
This is mega flimflam waiting to happen -- two marks seeking
something for nothing.
Enter our venerable financial engineers.
Our leading investment banks make a market in auction-rate
securities. These are long-term bonds that behaved until now like
short-term debt. Buyers take possession of the long-term bonds and are paid an
interest rate that is reset by auction every 7, 28 or 35 days. These securities
may change hands on these occasions. Hence, these become long-term paper an
investor could unload quickly. Their value does not change much if underlying
interest rates do not move too much between auctions -- hence the very short
terms between auctions.
Attracted to these instruments are wealthy individuals and
corporations with money to park.
Until now these securities did two things. First, they
permitted debtors and creditors to split the difference between the short-term
and long-term interest rate. The municipalities paid lower rates than those
required on long-term debt, and investors, who took possession of the long
debt, got a higher rate than they could get on ordinary short-term securities
and believed their investments were liquid and secure.
Second, the investment banks assumed the risk of an interest
rate jump caused by a shortage of buyers at auction. Marketing these securities
to investors as short-term paper, they would take possession of securities from
investors if a gap between buyers and sellers emerged at an auction,
potentially pushing up interest rates up too much.
Essentially, they became buyers of last resort to moderate
interest rate fluctuations and the resale value of securities for investors.
Banks ensured investors against interest rate risk.
Over the last several weeks, too few buyers have been
showing up at auctions and interest rates have rocketed. In large measure
investors are skittish about the kind of financial instruments investment banks
create in the wake of the mortgage-back collateralized debt fiasco.
On February 14, for example, the interest rate on some Port
Authority of New York and New Jersey debt jumped 20 percent to 4.2 percent when
part of its auction failed.
This meant that the banks would have to take a lot of
auction rate securities off their client's hands and take large losses on the
values of the underlying bonds. Remember when interest rates go up, the values
of the bonds go down.
Rather than taking possession of unsold securities, bankers
told investors their liquid investments are temporarily frozen and will be paid
the lower penalty rates issuers are bound to pay if the market doesn�t clear.
Now, many investment banks are pulling back or withdrawing
from the market.
These actions essentially shift interest rate risk and big
losses on the bonds from the investment banks back on to the private investors
and corporations who trusted them. Meanwhile, public agencies are stuck with
debt they can�t move and excessive borrowing costs.
The banks did not provide market-making and underwriting
services for free. They were paid generous fees and engineers received bonuses
in the millions. By presenting these securities to investors as liquid they
were insuring investors against interest rate risk -- at least investors
thought they were.
Once again, investment banks have betrayed their clients by
failing in their obligations and responsibilities.
Morici is a professor at the University of Maryland School of Business and
former Chief Economist at the U.S. International Trade Commission.