Paul Krugman’s latest column – below the fold.
A Crisis of Faith
Today, were witnessing another kind of contagion, not so much across countries as across markets. Troubles that began a little over a year ago in an obscure corner of the financial system, BBB-minus subprime-mortgage-backed securities, have spread to corporate bonds, auto loans, credit cards and now the latest casualty student loans.
Indeed, this week the state of Michigan suspended a major student-loan program because of the sudden collapse of another $300 billion market youve never heard of, the market for auction-rate securities.
Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, its more than a subprime crisis; indeed, its more than a housing crisis. Its a crisis of faith.
I know that sounds dramatic. But, let me talk about what just happened to auction-rate securities.
Like many of the financial innovations that are now being called into question, auction-rate securities are complicated deals that seemed to offer something for nothing.
They seemed to offer the borrowers typically local governments or quasi-governmental agencies, like the Port Authority of New York and New Jersey and the Michigan Higher Education Student Loan Authority a way to borrow long term without paying the relatively high interest rates investors usually demand on long-term loans.
At the same time, they seemed to offer investors an asset that was as good as cash readily available whenever needed but paid higher interest rates than bank deposits.
The operative word in all of this, of course, is seemed.
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 wasnt 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 interest 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 werent ever supposed to be failed auctions, so the penalties werent supposed to be relevant.
Now, what wasnt ever supposed to happen has. In the last few weeks, a series of auctions have failed, leaving investors who thought they had ready access to their cash stuck, even as borrowers find themselves paying penalty rates.
The collapse of the auction-rate security market doesnt reflect newly discovered problems with the borrowers: the Port Authority is as financially sound today as it was a month ago. Instead, its 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 theyll actually have the money to compensate losers in other markets.
More 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 function the way theyre supposed to after all, they know what happened to people who thought their subprime-backed 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 wont buy auction-rate securities because they no longer believe that theyre as good 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 whats happening as a sort of minor-key reprise of the banking crisis that swept America in 1930 and 1931. Frustrated investors who cant get their money out of auction-rate securities arent as photogenic as angry mobs milling outside closed banks, but the principle is the same. And so are the effects: would-be borrowers cant get credit, and the economy suffers.
One simple measure of the seriousness of the credit problem is this: although the Federal Reserve has sharply cut the interest rate it controls over the past few weeks, the borrowing costs facing many companies and households have actually gone up.
And the financial contagion is still spreading. What market is next?
I can feel a longstoush coming on.
Why?
US retail is already feeling it, with Christmas sales way down. Commercial real estate – especially malls and shopping centres, naturally – is also starting to hurt.
So the answer to “what market is next?” would seem to be: the real economy.
Why?
‘Cause I’d seen ’em elsewhere. But I was wrong. I guess people are all stoushed out. Maybe if this credit crunch leads to a Depression then we can recommence. The Left and Right can blame each other. :)
Always fun and so useful to.
Krugman always leaves out the important bits, mainly because he’s no longer an economist but a simply a deranged partisan pundit.
The Port authority is a mess and always has been. It’s a cross subsidized mountain of bad management, corruption and a union dominated feathered nest. The best that could happen to it is to cut it off from the capital markets and force the entity get its house in order- a long time coming.
At one stage the Port Authority owned Hotels!
There is an implicit guarantee from both NJ and NY State so it becomes difficult when people are looking around questioning credit risk.
Has the liquidity picture in the US deteriorated to such an extent that there is no money around as Krugman infers. NO!
One of the best economic consultancies in the world has this to say:
There is a massive mountain of U.S. investable cash sitting on the sidelines, earning an ever dwindling rate of interest. This cash pile will help buoy financial markets, but only once the buyers’ strike in the credit markets ends.
Cash is flowing into retail and institutional money market funds at a record pace, which reflects the extreme pessimism that exists towards risk assets. However, the desire to hold money market funds and T-bills will not last as aggressive interest rate cuts means that investors now receive unattractively low returns. It will still take a positive catalyst before sidelined cash gets re-deployed towards risk assets (i.e. an end to the credit crunch and less economic pessimism). However, the run-up in cash reserves underscores that there will be no shortage of liquidity to propel asset prices once risk-taking returns.
Krugman ignores the obvious in that credit will be in very short for those with suspect balance sheets that have relied on implicit guarantees in the past while ignoring their pathetic performance. This is a good thing. Credit is available for any decent proposition at a higher spread reflecting the risk spread that was ignored before.
Krugman is simply worried his pet causes are no longer getting an easy time. Typical.
It’s a golden rule that one must always check out what Krugman omits from his columns.
But the question here is not the soundness of the Port Authoritiy, it’s the soundness of the private-sector instruments they invested in.
Sure, “a positive catalyst” – an end to the recession.
No, some kinds of credit have dried up almost completely. And a huge spread is effective unavailability, in any case.
Bill P:
Without even taking a closer look at these securities it sounds to me that they were issuing (a sort of) perpetual bonds/notes. Maybe Krugman doesnt really understand this, or maybe he does and wanted to keep it quiet in order to get his argument across that things are bleak. You just never know with him as hes so bloody dishonest as a pundit.
This is the giveaway:
I can’t recall any perpetual security not ending in grief. At least in this case the underwriters had the presence of mind to build in a put option of sorts allowing for large penalties in case of a trigger event, which in this case being a shitty auction result. When a penalty such as in Krugman’s example comes into play it basically becomes a put option for all intents and purposes as its a sign that the market is locked for that issuer trying to raise money using that security.
Perpetual bonds are bad news for any investor, no matter who the issuer.
Well actually it hasn’t. You can buy sub-prime paper at cents in the dollar. I’ve been offered to join a syndicate to buy some of this junk at 30 cents in the dollar, or thereabouts.
The market hasn’t really seized in the strict sense. The market is doing the right thing in re-pricing all this crap much lower. You can buy sub-prime in the secondary market right now, however sellers are exhibiting sticker shocker.
Whats amusing is that you could very well find a good portion of these write downs may end up being massive write ups in the future.
My honest guess is that the audit firms not wanting to get blamed for another Enron type thing are being more than aggressive in forcing these huge write downs. Again, not all, but a good portion could actaully end up being written up.
The US yield curve has turned positive; it can be used as a reasonable sign that the worst may lay behind us. Not sure, but when Businessweek runs three consecutive editions spelling mass death and destruction it could mean the worst is behind us or at the very least the market has fully discounted the downside.
In sum, Krugman is trying to portray picture that liquidity has dried up. This is basically untrue. Can it get worse? It can if policy makers fuck up.
That’s interesting, and a steep discount. Is it worth buying, even at that price?
But it isn’t the provision of credit for productive activity. Take a look at the commercial mortgage backed market – it’s practically dead and spreads have blown out to, for some grades of credit, thousands of bp.
Yea, Bill, the CP paper market has basically closed for some old issuers. However I don’t think it is as bad as what people seem to portray otherwise there would be far more bankruptcies as they wouldn’t be able to roll over.
Yes the spread has moved out, but there are some truly interesting “bargains” that have opened up in the junk bond markets with some okish names trading at 800 to 1000 basis points over bench mark.
Dunno. I wouldn’t do it by myself as a lot of that paper is quite complex in terms of the provisions etc. You need examine such things as the geographical location of the paper too and try to steer clear of places like parts of Florida, Arizona etc.
That’s why it’s better to find a vulture fund with people that know what to look for as it really hard doing yourself. Make sure the principals have put up their own personal money in the fund as you want these guys to take some risk on themselves and not get a free option.
Happily, NG, since I also live in Melbourne I can promise to feed you if we have another even puny depression.
So you can indulge in Krugman’s silly worldview without fear!
Honestly, aren’t these things supposed to fail sometimes? Isn’t there a line somewhere about free lunches…?
The real issue at the moment is that almost no fundamentally sound businesses need cash so they aren’t asking for it.
As for Quiggin’s stupid AFR piece, well, let’s let history be the judge. I nominate three years as enough history. We can revisit both this Krugman and that Quiggin chicken little double act then!