The state of Virginia is proud of its AAA bond rating. Local governments, like Henrico, are fond of such ratings, too. But what happens when the larger bond market suddenly decides it won’t buy any bonds at all — AAA rated or not?
We’re seeing some of what can happen right now. Today’s Wall Street Journal has a piece on how one wealthy family told its bankers to stash their cash in the safest investment vehicles available. The results weren’t pretty:
The Mahers rank among the earliest victims of “auction rate” securities, a once-obscure type of bond now sending shock waves through broad swaths of the U.S. economy. Auction-rate securities — an unusual type of long-term bond that behaves like a short-term bond — have become a keystone of modern finance. They are routinely used to fund everything from college student-loan programs to municipal road-and-bridge projects.
These bonds became popular with investors looking for cashlike investments, because they offered better returns than traditional money-market investments but were just as easy to buy and sell.
Recently, however, that advantage has disappeared. The market for auction-rate securities has dried up amid fears about fallout from the subprime-mortgage crisis. This week, New York’s Port Authority saw the interest rate on some of its debt jump to 20% from 4.2% amid disruptions in this market.
We may not weep for the huge losses billionaires endure (the Mahers are still worth several hundred million dollars each), but the spreading trouble in auction-rate securities means even bigger problems for municipalities and local authorities issuing debt. The Port Authority’s example is truly eye-opening:
The Port Authority of New York and New Jersey’s interest rate jumped Tuesday to 20% from about 4.2% when bidders didn’t show up at an auction of its securities by Goldman Sachs Group Inc. For the next week at least — until the rate is reset again in the next auction — the Port Authority, which oversees New York-area transportation facilities such as bridges and tunnels, will have to pay close to $390,000 in interest payments to holders of the securities. That is up from $83,611 the week before, said a Port Authority spokesman.
Yes, the pain may be temporary. But the underlying affliction may take a long time to heal:
In less tumultuous times, the banks might be expected to step in and buy some of these securities themselves to help smooth the process. But their balance sheets are already stuffed with other holdings — loans to corporate borrowers, lines of credit to customers, mortgage debt and more — so they have decided not to intervene in this market.
As a result, well over $10 billion worth of auction-rate securities have been frozen. These included borrowings for Massachusetts prep school Deerfield Academy, Carnegie Hall and California’s De Young Museum, among many others.
Issuers have said that they were originally drawn to the auction-rate market because it offered them low short-term interest rates on long-term debt. It also gives them an easy way to pay down debt if they become cash rich: simply participate in the auction and take it back.
Investors have liked them because they have offered slightly higher interest rates than other plain-vanilla liquid holdings, such as Treasury bills. Corporate treasurers often hold them as alternatives to cash.
Now, they are having second thoughts. Several government and pension funds, some of which sustained steep losses during last year’s credit crisis, are rewriting their investment rules and are adopting more conservative strategies.
I do not know if any of Virginia’s bond debt, or that of its local governments and other debt-issuing authorities, is caught up in this latest crunch. But until the market works through its current problems, the debt window is a lot less friendly, and a lot more expensive, place than it was even a few weeks ago.
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