Monday, February 18, 2008

Quick Takes: Student Loan Auction Rate, CDS, and Condo Market

Auction Rate

The most immediate fall-out of the Auction Rate seize up this past week (see More Credit Turmoil: The Muni Auction Rate market freezes) was the student loan market. The failure left North Carolina and many other states scrambling to find new financing. More than two-thirds of our state’s $3.3 billion in student loans were financed using the auctions. It comes as a shock to many parents that the failure of this structured market may mean that no funding will be available to send junior to college this year. This is another example of the poor risk modeling and greed on Wall Street impacting Main Street.

The News and Observer article “Lenders need new financing: Student-loan providers scramble as key credit market fails” provided some very pertinent observations about the situation.

"The whole notion of a failed auction when I started 10 or 11 years ago was unthinkable," Brooks said. "The same could be said three weeks ago. I'm not sure when -- or if -- they are coming back."

The failure has nothing to do with the authority's credit rating or the value of its assets. Both are strong.

"But it speaks directly to people's confidence and trust in the credit markets," said UNC-Charlotte finance professor Tony Plath.

The failed auction stung some agencies harder than others.

The Michigan Higher Education Student Loan Authority announced Tuesday that it would suspend one of its lending programs after the auctions failed.

The auction rate market situation is not likely to improve in the upcoming months. The obvious result is the suspension of many student loan programs across the majority of states as government entities scramble to obtain new funding sources – the crucial problem being that most of these alternative sources will be at higher cost. This will immediately reduce the amount of available loan money and raise the costs for the students.

Credit Default Swaps

A new word for 2007 was subprime, for 2008 is will be Credit Default Swaps as this market implodes in a manner that makes subprime appear to be minor league. At least this is the growing opinion of many economists and media articles. The latest addition was the Arcane Market Is Next to Face Big Credit Test overview from the New York Times on Sunday. The article points out that the unregulated CDS market is enormous at $45.5 trillion in size, double the size of the stock market.

Worst of all the market is crumbling as participants are finding that many of the players will have trouble paying their obligations. As the default rate rises in the bond market, the CDS market will come under increasing pressure. Similar to subprime, a higher level of risk was never really priced into these structured CDS products. This likely sets the table for another credit market fiasco.

Downtown Condo Market

A mere few months ago, the media was hyping the downtown Condo market as resilient in a down real estate market. Outlining the high prices and large numbers of pre-sold units, the industry extrapolated that this trend would continue leading to more projects being planned. Fast forward to today’s business headline “Condo market goes sour: Demand for downtown units falls victim to troubles in home-sales market”

Developers are busy reducing the number of proposed units, cancelling projects, offering incentives, and trying to assist buyers with financing in a tightening credit market. It is starting look like the market for these over-priced units in downtown Raleigh have gone from gold mine to dust bowl.