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The Cost of Faith



February 16, 2008 – Comments (7)

Paul Krugman has an excellent piece on the municipal bond auction freezing up this past week.

It does a good job of explaining how this thing worked and what has happened and, well, here's a chunk of it:

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.



7 Comments – Post Your Own

#1) On February 16, 2008 at 10:21 AM, dwot (29.14) wrote:

This is another excellent piece on this whole mess, 

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#2) On February 16, 2008 at 11:45 AM, abitare (30.07) wrote:

"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

—Warren Buffett 

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#3) On February 16, 2008 at 12:07 PM, GS751 (26.86) wrote:

abiarecatania I think about that quote soo much when thinking about the financial markets.  It is not a subprime crisis we have it is a subprime economic system. 

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#4) On February 16, 2008 at 1:09 PM, LordZ wrote:

HMMM when people expect something for nothing, when they start complaining about their own rules and regulations, its funny, how your average person doesnt get much money in their savings account, yet the buying and selling of such simple things gets over complicated so that the common person has to rely on someone else to do something for nothing, then all the sudden the desire to invest in such things is gone and the few who understand it, now are requiring quite the larger sum of interest to get their money.

So can anyone tell me how I can benefit from this ????

What good is buying such a bond if you cant sell it ???

I may be a little confused but I know that a fool and his money is often parted...

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#5) On February 16, 2008 at 1:14 PM, LordZ wrote:

WHoa you have only 1 green and like 189 reds

I see you only like picking stocks to fail and underperform.

whats up with that...

Yeah its easier, but whats the point in finding and picking the losers of the bunch ???

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#6) On February 16, 2008 at 1:17 PM, Imperial1964 (94.19) wrote:

Z, you can profit from this by having cash around when there are good deals to be found.  Now is the time to accumulate the cash and develop a strategy for deploying it.

I think the really good deals will come along within the next 6 months.

By the way, where can I get a muni-bond yielding 20%??? 

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#7) On February 16, 2008 at 7:49 PM, HistoricalPEGuy (67.58) wrote:

Imperial is right on the money - make cash a significant part of your portfolio.

Also, Tobacco, Alcohol and Food related companies ususally do quite well in a recession.  I really like the idea of companies that produce "generic" brands or "private label".  Smokers don't stop smoking, drinkers don't stop drinking and everybody's got to eat.  They just find ways to do it cheaper.  Check out MO, BTI, BUD and CAG over the 1990-1991 recession.  This is just common wisdom, so take it with a grain of salt and do your own research!

-- HPEGuy

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