February 15, 2008The NewYork Times
A decade ago, during the last global financial crisis, the word on everyone’s lips was “contagion.” Troubles that began in a far-away country of which most people knew nothing (Thailand) eventually spread to much bigger countries with no obvious connection to Southeast Asia, like Russia and Brazil.
Today, we’re witnessing another kind of contagion, not so much across countries as across markets. Troubles that began a little over a year ago in an obscure corner of the financial system, BBB-minus subprime-mortgage-backed securities, have spread to corporate bonds, auto loans, credit cards and now — the latest casualty — student loans.
Indeed, this week the state of Michigan suspended a major student-loan program because of the sudden collapse of another $300 billion market you’ve never heard of, the market for auction-rate securities.
Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, it’s more than a subprime crisis; indeed, it’s more than a housing crisis. It’s a crisis of faith.
I know that sounds dramatic. But, let me talk about what just happened to auction-rate securities.
Like many of the financial innovations that are now being called into question, auction-rate securities are complicated deals that seemed to offer something for nothing.
They seemed to offer the borrowers — typically local governments or quasi-governmental agencies, like the Port Authority of New York and New Jersey and the Michigan Higher Education Student Loan Authority — a way to borrow long term without paying the relatively high interest rates investors usually demand on long-term loans.
At the same time, they seemed to offer investors an asset that was as good as cash — readily available whenever needed — but paid higher interest rates than bank deposits.
The operative word in all of this, of course, is “seemed.”
Auction-rate securities seemed as good as cash because they involve regular, well, auctions, held as often as once a week, in which investors wanting out sell their positions to investors wanting in. In principle, it was always possible for auctions to fail for lack of enough willing buyers — but that wasn’t ever supposed to happen.
Meanwhile, these securities seemed like a good deal for borrowers despite the fact that they contain a penalty clause: if an auction fails, the interest rate the borrower pays jumps up. (The Port Authority, which had a failed auction last week, just saw the interest rate it pays leap from 4.3 percent to 20 percent.) You see, there weren’t ever supposed to be failed auctions, so the penalties weren’t supposed to be relevant.
Now, what wasn’t ever supposed to happen has. In the last few weeks, a series of auctions have failed, leaving investors who thought they had ready access to their cash stuck, even as borrowers find themselves paying penalty rates.
The collapse of the auction-rate security market doesn’t reflect newly discovered problems with the borrowers: the Port Authority is as financially sound today as it was a month ago. Instead, it’s contagion from the broader credit crisis.
One channel of contagion involves monoline bond insurers, the specialized insurance companies that are supposed to guarantee debt. These companies insured buyers of local government debt against losses — but they also guaranteed a lot of subprime-related investments, which makes everyone wonder whether they’ll actually have the money to compensate losers in other markets.
More important, however, is the way the ever-widening financial crisis has shaken investors’ faith in the whole system. People no longer trust assurances that fancy financial instruments will function the way they’re supposed to — after all, they know what happened to people who thought their subprime-backed securities were safe, AAA-rated investments. Why, then, should they believe that auction-rate securities are as good as cash?
And loss of trust can be a self-fulfilling prophecy. Now that new investors won’t buy auction-rate securities because they no longer believe that they’re as good as cash, those securities become a much worse investment.
Needless to say, all of this is bad for the economy. I like to think of what’s happening as a sort of minor-key reprise of the banking crisis that swept America in 1930 and 1931. Frustrated investors who can’t get their money out of auction-rate securities aren’t as photogenic as angry mobs milling outside closed banks, but the principle is the same. And so are the effects: would-be borrowers can’t get credit, and the economy suffers.
One simple measure of the seriousness of the credit problem is this: although the Federal Reserve has sharply cut the interest rate it controls over the past few weeks, the borrowing costs facing many companies and households have actually gone up.
And the financial contagion is still spreading. What market is next?
