Peter Morici is an economist and professor at the Robert H. Smith School of Business at the University of Maryland. He is a recognized expert on international economics, industrial policy and macroeconomics. Prior to joining the university, he served as director of the Office of Economics at the US International Trade Commission.

I don’t know how Broadway sells tickets these days when folly is in so plain array on Wall Street. Auction-rate securities drama provides the latest tale of greed and betrayal.

Investors are stuck with big losses, because investment banks miscalculated their own risks and are putting it to their clients, again.

Municipalities and public agencies, like the New York Dormitory Authority, require long-term financing for big projects.

As we learn in Economics One, the yield curve slopes up. Governments and businesses generally pay higher rates on 30-year bonds than 30-day notes, in part owing to the possibility that interest rates on new bonds may rise in the future.

When interest rates go up, existing bonds become worth less than their original sale value and their owners take a loss. What we call interest rate risk.

Public agencies as well as others needing long-term cash would like to get long-term money at short-term rates. This is like an opera lover seeking box seats for balcony prices.

Conversely, investors would like to lend money only for the short-term but get those higher long-term rates. The opera company selling balcony seats at box prices.

This is mega flimflam waiting to happen--two marks seeking something for nothing.

Enter our venerable financial engineers.

Our leading investment banks make a market in auction-rate securities. These are long-term bonds that behaved until now like short-term debt. Buyers take possession of the long-term bonds and are paid an interest rate that is reset by auction every 7, 28 or 35 days. These securities may change hands on these occasions. Hence, these become long-term paper an investor could unload quickly. Their value does not change much if underlying interest rates do not move too much between auctions—hence the very short terms between auctions.

Attracted to these instruments are wealthy individuals and corporations with money to park.

Until now these securities did two things. First, they permitted debtors and creditors to split the difference between the short-term and long-term interest rate. The municipalities paid lower rates than those required on long-term debt, and investors, who took possession of the long debt, got a higher rate than they could get on ordinary short-term securities and believed their investments were liquid and secure.

Second, the investment banks assumed the risk of an interest rate jump caused by a shortage of buyers at auction. Marketing these securities to investors as short-term paper, they would take possession of securities from investors if a gap between buyers and sellers emerged at an auction, potentially pushing up interest rates up too much.

Essentially, they became buyers of last resort to moderate interest rate fluctuations and the resale value of securities for investors. Banks ensured investors against interest rate risk.

Over the last several weeks, too few buyers have been showing up at auctions and interest rates have rocketed. In large measure investors are skittish about the kind of financial instruments investment banks create in the wake of the mortgage-back collateralized debt fiasco.

On February 14, for example, the interest rate on some Port Authority of New York and New Jersey debt jumped 20 percent to 4.2 percent when part of its auction failed.

This meant that the banks would have to take a lot of auction rate securities off their client’s hands and take large losses on the values of the underlying bonds. Remember when interest rates go up, the values of the bonds go down.

Rather than taking possession of unsold securities, bankers told investors their liquid investments are temporarily frozen and will be paid the lower penalty rates issuers are bound to pay if the market doesn’t clear.

Now, many investment banks are pulling back or withdrawing from the market.

These actions essentially shift interest rate risk and big losses on the bonds from the investment banks back on to the private investors and corporations who trusted them. Meanwhile, public agencies are stuck with debt they can’t move and excessive borrowing costs.

The banks did not provide market-making and underwriting services for free. They were paid generous fees and engineers received bonuses in the millions. By presenting these securities to investors as liquid they were insuring investors against interest rate risk—at least investors thought they were.

Once again, investment banks have betrayed their clients by failing in their obligations and responsibilities.

Peter Morici,

Professor, Robert H. Smith School of Business, University of Maryland,

College Park, MD 20742-1815,

703 549 4338 Phone

703 618 4338 Cell Phone

pmorici@rhsmith.umd.edu

http://www.smith.umd.edu/lbpp/faculty/morici.html

http://www.smith.umd.edu/faculty/pmorici/cv_pmorici.htm