Much of the auction rate debt was issued in lieu of standard, fixed rate municipal bonds.  It naively appeared to be a “win-win” situation.  Municipal issuers could borrow money for long term capital projects at short term interest rates. Lenders could get the liquidity of short maturity Treasury Bills but at higher interest yields. This was an unusual market situation caused by a surplus of liquidity in the US from 2004 through 2007 due to simulative monetary policy by the FRB and massive capital inflows into the US.

This brief window of surplus liquidity began to close late last year when subprime mortgage defaults soared. Both bond issuers and bond holders were trapped with an unusual security designed for abnormal conditions in the financial market.

Auction rate securities are long term loans that are brought to an auction as often as every seven days and sold to new holders at the highest bond price/lowest interest rate that clears the market – all bonds are sold. With surplus liquidity there were always enough buyers and interest remained below municipal bond rates.  Rarely, when there was a shortage of buyers, the investment bank that brokered the original loan would step in and buy on its own account.

Early this year buyers left the auction rate securities market as they began to conserve their scarce capital in the initial stages of the credit crunch that appeared in the last month. The investment banks also needed to conserve capital so they stopped buying auction rate bonds that their customers declined to buy and the auctions “failed”.

This meant that interest rates were reset to high penalty rates to compensate bondholders for the loss of liquidity.  No one was happy.  Bondholders though they had bought they had bough short maturity assets that they could sell, if necessary, every 7 or 30 days. Bond issuers thought they had borrowed at short term rates but were now stuck with high penalty rates.

A major source of public works funding was shut down and some municipalities had their budgets destroyed by unexpectedly high credit costs. New projects began to be delayed last spring and work was slowed on some ongoing projects.

A coalition of state attorneys general is providing some relief for municipal treasurers by getting court approved agreements requiring investment banks to buy back the auction rate securities from current bond holders and to adjust the penalty interest rates down.  Few of these checks are in the mail yet. The last of them will not arrive until well into next year. Meanwhile, municipal project cutbacks will continue.

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