Tuesday, February 19, 2008

bonds and you

Think all the esoteric news on the bond market does not have that much local impact... Here is something even more complex than the confusion in the bond insurance market: A failed bond offering I read about last week has rolled into a crisis impacting UPMC to the tune of $500k per week. But they are working to unwind it. See this Bloomberg news item: Pittsburgh Hospital Redeems `Loan Shark' Auction Debt.

Update: An update and further context from Bloomberg as well: New York Bonds Cost Rise as Banks Let Auctions Fail.

Update 2: NYT has more coverage and more explanation today: Auctions Yield Chaos for Bonds . One quote in there says that the current crisis could "could push up the rates that cities and states must pay to borrow money". Some dots just spontaneously connect themselves. Anyone? And it may be interesting to reread where this all started which is Bill Ackman's treatise: Is MBIA Triple A?

11 Comments:

Blogger Felix Dzerzhinsky said...

Chris: I'm missing something here; why have the banks stopped bidding on auction-rate securities?

Funny how volatility has entered the debt market, when it used to be the sole province of the equity markets.

Tuesday, February 19, 2008 11:37:00 AM  
Blogger C. Briem said...

The superficial answer is somebody screwed up... no way a bond should have been priced such that this happens. but the real question is how that happened. To that my days at Lehman are long ago to begin to answer. I speculate that the big picture is that following the MBIA/bond insurance debacles I wonder if people are taking a real look at bond risks.

which is a lot of words to hide the fact that I don't know.

Tuesday, February 19, 2008 11:43:00 AM  
Blogger C. Briem said...

or to put some long words on it: information asymmetry between the sellers and buyers.

Tuesday, February 19, 2008 11:44:00 AM  
Blogger C. Briem said...

or to put some long words on it: information asymmetry between the sellers and buyers.

Tuesday, February 19, 2008 11:44:00 AM  
Blogger EdHeath said...

This story may help too: http://www.nytimes.com/2008/02/15/business/15place.html?sq=auction%20bond&st=cse&adxnnl=1&scp=2&adxnnlx=1203440553-bdV4lLWl79E4ilw6PZ+4pQ

It appears that banks are jamming up auctions for securities by backing aware from guaranteeing them. Maybe. Is this a liquidity crisis in the making? Maybe your advice for Presidents Day, the Original Mattress Factory, was more timely than you thought. They may experience a run on their "built in safe" model.

Meanwhile UPMC is now spending some of their excess margin to get out the confusing whole they are in. Maybe it was a good thing that they had that margin.

And perhaps the joint Bush/Congress stimulus package will be seen as genius, as ordinary taxpayers inject liquidity into banks by paying down credit card debt.

Tuesday, February 19, 2008 12:15:00 PM  
Blogger EdHeath said...

er, UPMC is in a hole, not a whole...

Tuesday, February 19, 2008 12:16:00 PM  
Blogger Felix Dzerzhinsky said...

Ed: Most of UPMC's excess margin was due to their investment activities and not operations, actually. Though I think even their losses here have not even come close to matching their profits in previous years. They should get 100% of the blame for their losses anyway; it's their fault that they decided to put so much money into an exotic, newish financial instrument that turns out to have been based on a scam by the banks anyway.

Chris: Tell me if I'm getting the basics straight here, since I'm not an expert on this stuff and would like clarification:

(1) The big obligors who issue munis want a way to pay even lower interest rates. Underwriters propose these auction-rate bonds as a way to do that.

(2) The banks market these bonds to wealthy investors, giving them the impression that they are basically as liquid as cash, except that they will give a better return than, say, a money market account.

(3) The banks essentially guarantee a low interest rate to the obligors by offering bids at the auctions, which occur as often as every month or even every week. (I'm unclear on why they do this -- to give the general impression that there is always a market, thereby making the bonds more attractive to investors, as well as keeping the obligors happy?)

(4) Credit crunch brought on by the banks' mortgage scams lead them to close down the auction-rate securities market, including the auctions of already-existing securities. They essentially say "Sorry, suckers" to investors (not just small investors either, but the kind of "high-net worth individuals" who buy munis -- always the wrong whiteys to f*#! with), your investments are not so liquid after all -- and a whole lot of rich people discover that their money is tied up in long-term securities that the banks misrepresented as short-term.

(5) They also stop putting in bids at the auctions. A few speculators figure out that they can make a killing by putting in bids at just below the "penalty" interest rate on the bonds, gouging the issuers.

(6) UPMC, it seems, is one of the first big issuers to say "Screw this" and just refinance, very likely putting an end to the auction-rate securities market for good. At least for AA rated issuers -- maybe other issuers (like West Penn Allegheny -- ha ha!) will always have the option of "variable rate" securities, sort of like low-income people could get variable rate mortgages until recently.

Am I basically right on this or am I misunderstanding something?

Tuesday, February 19, 2008 7:16:00 PM  
Blogger Felix Dzerzhinsky said...

Chris: One other thing. It doesn't seem to me that this would have to do with bond risks, since a lot of the credits involved are pretty highly-rated (UPMC is AA). It all has to do with the resale market, with banks having offered investors a way to game the tax-exempt bond market for short-term gains the way they would the stock market -- save that the bottom fell out when the banks stopped guaranteeing the whole thing by putting in their own bids at the auctions.

Correct me if I'm wrong . . .

Tuesday, February 19, 2008 7:35:00 PM  
Blogger C. Briem said...

I probably can’t answer. I will admit that I don’t know much about the auction rate bond market in itself. Conceptually I think of them as the inflation adjusted t-bills, of course the issuer isn’t the Fed which is the problem. All looks like a mechanism to lower risk premia in a market, yet in the end only introduced a lot more risk. Do I think that synopsis is correct? I think so, but it focuses on the shenanigans in the machinations. The question is why this happened in the first place. The IHT last November has this clear foreshadowing:

http://www.iht.com/articles/2007/11/21/bloomberg/bxinvest.php

Which tells me that it is all a market with some completely lopsided information access to the players. Makes you wonder why it worked at all. It may not be about the credit ratings of the issuers is true enough, but it looks like the market in some cases didn’t care about credit ratings at all. Some of that was sheer panic, but some of it was just lack of faith in a market with a limited track record. I am speculating, but it seems like the market as it operated presumed a certain backing by the institutional banks to backstop it, or at the very least to act as market makers when in reality that backing didn’t exist at all. Letting these markets fail is quite an event that I bet will get legal scrutiny in some form down the road. UMPC’s situation and other losses are really the collateral damage to some more fundamental issues.

Was this investment ‘exotic’? In the big scheme of things I wouldn’t use that term. In the heyday of derivatives I swear there were new financial products being developed every day with some completely unquantifiable risks. There were banks of PhD physicists just trying to work out the hedges and it was clear they were not always getting it right. Lots of bad calls out there from LTCM to other failed hedge funds.. and those were just the bad decision cases, essentially bad bets but bets nonetheless. The cases of outright cluelessness are even scarier. The rather inexperienced fellow who lost $7 Billion for the French Bank just last month is still not well explained. I remember the fellow Jett who brought down Kidder Peabody. If you listened to his explanation at the time, he didn’t do anything wrong and there was something wrong in the accounting software. This market was not overly complex, but not fully understood and clearly unproven through difficult times.

Tuesday, February 19, 2008 10:02:00 PM  
Blogger fester said...

Sorry for getting into this late -- but Felix basically has it right but is attributing a little too much malice and competent quasi conspiracy when a much simpler explanation can explain the banks' behaviors:

The banks are broke and have no real capital reserves that they can lend out at 5.5% and that is why they stopped backing the ARS market even when the ARS is issued by UPMC or other good credit risk. Throw in what Chris is hitting on about information asymmetry, and that is the basic story.

Thursday, February 21, 2008 6:56:00 PM  
Blogger C. Briem said...

yeah, sure... but that only begs several more questions. Was there really nobody who could find an arbitrage opportunity between 5.5% and near 20%.

Thursday, February 21, 2008 9:57:00 PM  

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