Financial Management: Hair of the dog
A number of years ago, Wall Street found a new use for an old product: Auction rate preferred stock was re-configured into “auction rate securities” as a substitute for variable rate bonds issued by local and state governments with “put,” or right to sell, options. The new securities were marketed on a premise attractive to both investor and issuer: there was no need for bank support because the securities were inherently liquid, and the prospect of failing to resell the bonds was unthinkable.
In the new way of thinking, investors received a higher yield for taking the risk of being unable to resell the security, and issuers saved money by eliminating the cost of the bank support. The Wall Street banks assured issuers and investors that they would support the programs in the unlikely event that they could not resell the bonds. Each party was relying on the premise that liquidity would always be available in the market — a questionable assumption.
For a while, the process worked well; issuers benefited from low cost, simple re-marketing and no bank support expense. Investors experienced good liquidity. The market grew to an estimated $300 billion. Then, the real estate lending bubble burst, as speculative bubbles always do. The market for auction rate securities stopped functioning when the banks, who had touted them, stopped taking securities that did not receive new “roll-over” bids onto their balance sheets. The implied liquidity had vanished. The lesson to be learned — again — is that no one is big enough (or possesses deep enough pockets) to outwit the market.
While the discussion about those events is focused primarily on the banks, the real losers were the investors and municipal issuers. Investors had no liquidity, and issuers paid significantly higher interest than they had bargained for. As a result, numerous issuers attempted to restructure the devices into more conventional variable rate arrangements supported by letters of credit. That was occurring just as the banking system was dealing with a massive de-leveraging. What started as a liquidity crisis ended up as a true credit crisis for municipal issuers.
Warren Buffett, in a recent letter to shareholders, quoted a CEO of a major bank on the matter of “weakened lending practices” who said, “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.” As the markets evolve in 2009, issuers seeking bank support will experience some daunting conditions: credit will remain much tighter, and it certainly will be more costly than it has been in many years. Banks will be extremely finicky about credit quality. Regardless, financially sound issuers still should be able to access the bank market for support. Cost will be the driver. Stand-alone credits, such as strong, tax-supported issues and enterprise revenue issues with good income streams, always will be welcome in a market that seems to be retreating from “new ways to lose money.”
Timothy Schaefer is a public finance consultant based in Newport Beach, Calif.
