Another arcane area of the bond market has been hit by the credit crunch, says The Economist: the auction-rate securities market, which is worth $330bn.
It involves providing short-term funding for long-term municipal commitments. An authority turns over a bond through an auction at intervals ranging from a week to a month, a process that costs it less overall than simply issuing a long-term bond. Should an auction fail, the borrower's interest rate on the loan rises, often quite dramatically, so that whoever ends up with the bonds is compensated for the loss of liquidity.
Last week, "markets shut down for the good and the bad alike", says Randall Forsyth in Barron's. There has been a buyers' strike as investors' confidence in the monoline insurers, who guarantee most municipal debt, has collapsed.
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Moreover, investment banks, who normally run the auctions, are stepping back owing to constraints on their balance sheets. Of auctions held last Wednesday, 80% failed, sending the cost of debt ultimately funded by the taxpayer rocketing. The Port Authority of New York and New Jersey, hardly a risky borrower, ended up paying 20% rather than 4% on their loan costing them an extra $300,000 a week.
Major issuers are likely to find another way to fund themselves. But as John Mauldin points out on InvestorsInsight, higher interest rates "are a serious blow" to some smaller issuers; school or hospital districts could now have to make "ugly choices" about where to cut their budgets. As Marco Annunziata of UniCredit says, "tighter credit conditions are being felt by more and more players in the economy".
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