You may remember that a lot of people in America bought their homes using adjustable rate mortgages, even though fixed mortgages were near historic lows. Well, some local governments did the same thing, only worse. The worse is called auction-rate securities and they are becoming the newest disaster on Wall Street.
The process is simple:
- Local government borrows money long-term, 30 years is popular.
- Instead of paying fixed rate, the interest rate is bid on every 7 to 35 days by investors.
- Local government pays the interest bid, whatever it is.
- Repeat for thirty years.
In normal times, short-term interest costs less than long-term interest, but it is more volatile and, if long-term rates are near historic lows, the savings from short-term are minimal.
Today, of course, we are not in normal times. The Port Authority of New York and New Jersey has its interest on an auction-rate tax-free municipal bond series go up to 20% interest this week after last week's 4.2%.
Why? There is little risk of default and most municipal bonds that have some risk are insured by municipal bond insurers like MBIA and Ambac. Unfortunately, the municipal bond insurers made some investments and some guarantees that were hit hard by the credit tumult of the past six months. Wary investors are valuing the credit insurance at zero. Even more importantly, the banks that made the money on fees with this wonderful new idea are standing aside watching this happen rather than buying the bonds when the interest rate goes above market.
Normally, banks will buy the bonds rather than see absurd results like 20% interest. They have an interest in keeping the market going. Municipal bonds are a very profitable sector of Wall Street. Auction-rate was even more profitable because it allows for continuing fees. By not buying the bonds at a reasonable yield, they may have killed the market for good. This may not be a bad thing, at least not in today's low interest environment. The most highly rated municipalities are paying 4.4% for thirty-year loans. 10-year are 3.4%. Short term is well below 3%, but as the example above shows, even the best bonds are not guaranteed to get that with the auction-rate bonds.
How does a local government plan when they don't even know what their interest rates will be next week for the bonds they have? Just as Orange County's less-than-brilliant attempt to make money with speculative investments left them $1.6 billion poorer in 1994, so we are seeing another way in which Wall Street has managed to get local governments to assume risks that they don't understand, are not prepared for, and violates their fiduciary responsibility to their taxpayers because it is in the interests of the firms that are selling and managing the bonds. Let's hope that this very bad idea disappears quickly.