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 wans'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 interst 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 penaties weren't supposed to be relevant.
Now, what wasn't ever supposed to happen has. In the last few weeks, a series of auctions have failed, leaving investors who thought they had redy access to their cash stuck, even as borrowers find themselves paying penatly rates.
The collapse of the auction-rate security market doesn't relfect newly discovered problems with the borrowers: the Port Authority is as financially sound today as it was a month ago. Instead, it's contagion from the broader credit crisis.
One channel of contagion involves monoline bond insurers, the specialized insurance companies that are supposed to guarantee debt. These companies insured buyers of local government debt against losses --- but they also guaranteed a lot of subprime-related investments, which makes everyone wonder whether they'll actually have the money to compensate losers in other markets.
Most important, however, is the way the ever-widening financial crisis has shaken investors' faith in the whole system. People no longer trust assurances that fancy financial instruments will functin the way they're supposed to --- after all, they know what happened to people who thought their subprime-back securities were safe, AAA-rated investments. Why, then, should they believe that auction-rate securities are as good as cash?
And loss of trust can be a self-fulfilling prophecy. Now that new investors won't buy auction-rate securities because they no longer believe that they're as dood as cash, those securities become a much worse investment.
Needless to say, all of this is bad for the economy. I like to think of what's happening as a sort of minor-key reprise of the banking crisis that swept America in 1930 and 1931. Frustrated investors who can't get their money out of auction-rate securities aren't as photogenic as angry mobs milling outside closed banks, but the principle is the same. And so are the effects: would-be borrowers can't get credit, and the economy suffers.
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