FacebookTwitterGoogle+RedditEmail

The Auction-Rate Securities Fiasco

by PETER MORICI

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 One, 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.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

 

 

 

 

More articles by:

PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.

CounterPunch Magazine

minimag-edit

bernie-the-sandernistas-cover-344x550

zen economics

Weekend Edition
July 21, 2017
Friday - Sunday
Kevin Zeese
Green Party Growing Pains; Our Own Crisis of Democracy
Jeffrey St. Clair
Red State, Blue State; Green State, Deep State
Paul Street
“Inclusive Capitalism,” Nancy Pelosi, and the Dying Planet
Anthony DiMaggio
Higher Education Fallacies: What’s Behind Rising Conservative Distrust of Learning?
Andrew Levine
Why Republicans Won’t Dump Trump Anytime Soon
Michael Colby
Ben & Jerry’s Has No Clothes
Bruce Dixon
White Liberal Guilt, Black Opportunism and the Green Party
Edward Hunt
Killing Civilians in Iraq and Syria
Matthew Kovac
Is the Flint Water Crisis a Crime Against Humanity?
Mark Harris
The Revolutionary Imagination: Rosa for Our Times
David Rosen
America’s Five Sex Panics
Robert Fisk
Saudi Arabia: the Kingdom Whose Name We Dare Not Speak At All
Jack Heyman
Class War on the Waterfront: Longshore Workers Under Attack
Kim C. Domenico
Marginalize This:  Turning the Tables on Neoliberal Triumphalism
Brian Cloughley
Trying to Negotiate With the United States
John Laforge
Activists Challenge US Nukes in Germany; Occupy Bunker Deep Inside Nuclear Weapons Base
Jonathan Latham
The Biotech Industry is Taking Over the Regulation of GMOs From the Inside
Russell Mokhiber
DC Disciplinary Counsel Hamilton Fox Won’t Let Whistleblower Lawyer Lynne Bernabei Go
Ramzy Baroud
The Story Behind the Jerusalem Attack: How Trump and Netanyahu Pushed Palestinians to A Corner
Farzana Versey
The Murder of Muslims
Kathy Kelly
At Every Door
David W. Pear
Venezuela Under Siege by U.S. Empire
Maria Paez Victor
Venezuelan Opposition Now Opposes the People
Uri Avnery
Soros’ Sorrows
Joseph Natoli
The Mythos Meme of Choice
Clark T. Scott
High Confidence and Low Methods
Missy Comley Beattie
Glioblastoma As Metaphor
Ann Garrison
Organizing Pennsylvania’s 197: Cheri Honkala on Frontline Communities
Ted Rall
What Happened When I Represented Myself as My Own Lawyer
Colin Todhunter
Codex Alimentarius and Monsanto’s Toxic Relations
Graham Peebles
Europe’s Shameful Refugee Policy
Louis Proyect
Reversals of Imperial Fortune: From the Comanche to Vietnam
Stephen Cooper
Gov. Kasich: “Amazing Grace” Starts With You! 
Jeffrey Wilson
Demolish! The Story of One Detroit Resident’s Home
REZA FIYOUZAT
Billionaire In Panic Over Dems’ Self-Destruct
David Penner
The Barbarism of Privatized Health Care
Yves Engler
Canada in Zambia
Ludwig Watzal
What Israel is Really All About
Randy Shields
Matters of National Insecurity
Vacy Vlanza
The Ministry of Utmost Happiness: Through Eyes of an Activist for Palestine
Cesar Chelala
Dr. Schweitzer’s Lost Message
Masturah Alatas
Becoming Italian
Martin Billheimer
Lessons Paid in Full
Charles R. Larson
Review: James Q. Whitman’s “Hitler’s American Model”
David Yearsley
The Brilliance of Velasquez
FacebookTwitterGoogle+RedditEmail