Friday, February 15, 2008

More Credit Turmoil: The Muni Auction Rate market freezes

The auction-rate market is locked up tight. Major brokerage firms such as Goldman Sachs is refusing to let well-heeled investors to withdraw money from these securities which were marketed as “safe as cash”. This has left many of these investors furious at being stiffed by the brokerage firms in what has been labeled New Trouble in Auction-Rate Securities.

The auction-rate market is dominated by municipalities and other tax-exempt institutions; this means that the credit crunch is moving over to the muni market. Not only are the bond insurers such as MBIA and Ambac in disarray, the entire market can not price securities in auctions.

These bonds are long-term securities despite being marketed as cash equivalents to customers. The banks hold weekly or monthly auctions to set the interest rates and give holders the option of selling the securities at these times. This week the market totally froze up, nearly 1,000 of these auctions failed. Furthermore the banks also refused to support the auctions as agents of last resort – leaving all the investors wondering if they will ever get any money back.

Now Goldman, Lehman Brothers, Merrill Lynch and other banks are informing investors the market for these securities is frozen. It is doubtful that investors in this market will see any cash in the next few months. The situation further throws a wrench into the health prospects of the entire municipal bond market.

Looking at the credit market problems from a broader perspective, Nouriel Roubini came out with a summary this past Monday that is a must read for all investors - The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster.

In this article, he outlines the prospects and dimensions of a downward credit cycle leading to a systemic financial meltdown. The introduction states that “Such a scenario - however extreme - has a rising and significant probability of occurring.” The article moves on to detail the likely outcome of an event that would usually be labeled a severe economic recession.

For today’s simple economic lesson: Squeezing Oranges – Good. Squeezing Credit – Bad
Any questions?