The stock market continues its volatility, but the underlying cause of the crisis still hasn’t been dealt with, and the crisis is now spreading to other parts of the credit market.
New York state taxpayers’ weekly borrowing costs increased $2.3 million after banks failed to attract bidders to auction-rate bonds and stopped buying unwanted securities.
Interest rates on Dormitory Authority bonds sold for the City University of New York rose to as high as 6.26 percent last week from 3.42 percent on Feb. 6, according to data compiled by Bloomberg. Buffalo’s rate on water system revenue bonds soared to 11 percent from 3.30 percent. Bonds issued by the Museum of Modern Art climbed to 4.47 percent on Feb. 13 from 3 percent at the end of January.
Rates in the $330 billion auction-rate bond market are rising nationwide after banks from Citigroup Inc. to Goldman Sachs Group Inc. stopped bidding for the debt at periodic sales they oversee, according to Bloomberg data. New York, with $4 billion of auction debt, may convert the bonds to a fixed rate or a different type of variable-rate security, state budget director Laura Anglin said in an interview in Albany last week.
“It hurts,” said Anthony Farina, executive assistant in the Buffalo comptroller’s office. Interest costs on the $63 million of auction-rate bonds rose $93,000 for the week, he said. “Nobody expected this kind of jump.”
Nationwide the credit crisis is beginning to have a pronounced real world effect on local, county, and state governments. Rates for borrowing money for public improvements and general use, done through bond auctions, are skyrocketing.
Nobody’s buying the bonds. These are largely short term auctions that change from week to week and are as generally liquid as cash, the whole point of these auctions is to serve as reliable short-term investments.
If nobody’s buying these bonds at auction, the entire system is threatening to break down. What’s the point of a short term liquid investment if you can’t unload it when you need to?
The worst part is that when these auctions fail, the municipalities that are funded by the bonds get jacked up to the top penalty rates. It used to be fine because of course, these auctions never failed to find buyers.
Until a few weeks ago, that is. Now this whole section of the credit market is coming apart.
Auction-rate debt used to be the cheapest form of borrowing for New York, according to a Budget Division report. When 28 of 43 auctions failed to attract enough bids last week, the securities became the most expensive type of debt for the state. Across the U.S., more than 100 auctions failed.
Rates on New York’s seven-day auction bonds last week ranged from 6.26 percent on the dormitory bonds to 3.14 percent for general obligations. The state is paying about 3 percentage points more on its auction debt than on variable-rate bonds it uses as a benchmark, state data shows. In the past, the state paid less on its auction debt than the benchmark.
So how does this affect you? A lot of things are funded by this short-term bond rate racket. Things like…hospitals.
The University of Pittsburgh Medical Center plans to redeem $430 million of its bonds to stem as much as $500,000 a week in losses caused by a crisis roiling the market for so-called auction-rate securities.
The hospital offered to buy back $91 million of its debt yesterday, and will make similar offers for almost $340 million more, according to Tal Heppenstall, UPMC’s treasurer. Holders have until March 19 to sell the bonds back for $100.01 of par value plus accrued interest, according to a notice posted on Bloomberg.
Funding costs soared nationwide in the $330 billion market for auction-rate securities as banks from Citigroup Inc. to Goldman Sachs Group Inc. stopped bidding for the debt at the periodic sales they organize. New York state, with $4 billion of auction debt, may convert the bonds to a fixed rate or a different type of variable-rate security, state budget director Laura Anglin said in an interview in Albany last week.
“It’s outrageous,” Heppenstall said. “We’re a AA-rated credit. We don’t need to get financing from loan sharks.”
Expect to see a lot more of this type of thing in the coming weeks and months, followed by holders of these bonds having to face some way to pay the new penalty rate interest or risk defaulting on the bonds.
Expect to see quick funding cuts, tax increases, and decreases in services at the local level as this spreads. A whole hell of a lot of local and county budgets are about to go deep into the red very quickly.
But that’s not the real issue. The real issue is still bank solvency, and this latest news is pretty grim.
US banks have been quietly borrowing massive amounts of money from the Federal Reserve in recent weeks by using a new measure the Fed introduced two months ago to help ease the credit crunch.
The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.
$50 billion is no joke. The banks are pretty desperate right now and this basically amounts to a bailout. There’s already a mechanism in place for banks to get money at a lower rate, the so called “discount window”. However, taking money from the discount window is an admission that the bank’s reserves are close to failure.
Yet, $50 billion has been borrowed since December. How is this possible? This would be front page news. Banks borrowing that much money on the discount window would be the end of the financial sector, stocks would get crushed overnight. Confidence in the banks would vanish.
But the banks still got the money and the discount window hasn’t been touched. The shell game is back in play…and it’s worse than you think. Note the borrowing is all coming through the Fed’s term auction facility. What does that mean?
“The TAF … allows the banks to borrow money against all sort of dodgy collateral,” says Christopher Wood, analyst at CLSA. “The banks are increasingly giving the Fed the garbage collateral nobody else wants to take … [this] suggests a perilous condition for America’s banking system.”
Guess what that “dodgy, garbage collateral” is.
If you said “increasingly worthless commercial paper, CDOs, SIVs, and credit default swaps” then you’re a winner…and in the end you’re also a loser. We all are. Because we’re already bailing out the banks.
To recap, banks are basically getting billions in one-month loans by putting up basically worthless subprime/credit swap/commercial paper as collateral. If the banks can’t pay it back, the government collects…worthless crap.
In other words, the banks have found a buyer for this worthless paper: the US Government. And they are unloading it for cash at fire sale prices, all with the added effect of inflation, pouring money into the system at the rate of billions a week.
Meanwhile, the rest of the credit market is still wobbly. Banks still can’t unload the paper crap quickly enough. So what happens should the banks default? Again, the basic question of bank solvency is not being addressed by this. Banks still have trillions in questionable paper on their books that if they write off, they will be finished. The derivatives they have leveraged are worth orders of magnitude more than the bank actually has in assets.
The Fed announced the TAF tool on December 12 as part of a co-ordinated package of measures unveiled by leading western central banks to calm money markets.
The measure marks a distinct break from past US policy. Before its introduction, banks either had to raise money in the open market or use the so-called “discount window” for emergencies. However, last year many banks refused to use the discount window, even though they found it hard to raise funds in the market, because it was associated with the stigma of bank failure.
The Fed has not yet indicated how long the TAF will remain in place.
But the popularity of the scheme is prompting speculation the reform will stay in place as long as the financial stresses last.
“Some Fed officials have expressed an interest in keeping and possibly expanding the TAF,” says Michael Feroli, economist at JPMorgan.
Nevertheless, Mr Feroli said banks now appeared to be using the TAF instead of other funding routes, meaning that the overall level of reserves in the system was remaining constant. “The banking system certainly has its problems, however the notion that … banks have trouble maintaining reserves stems from a superficial reading of the Fed’s statistical reports,” he said.
So the banks will continue to unload worthless paper on the government, and the government will supply billions in return. The problem is the banks aren’t going to be able to buy or sell other credit assets with these short term loans because…there are no buyers. Other banks aren’t going to take the toxic waste. So, the banks will have their money…but they’ll have far more in increasingly larger derivative losses. To pour enough money into the system to really bail the banks out will take hundreds of trillions of dollars.
It’s hyper-inflation without the fanfare, but it’s still hyper-inflation. If there are no buyers in the derivative market and only sellers, it doesn’t matter how much money the Fed tries to throw at the problem. The credit market still locks up like an engine without oil in it.
And when that happens, boom.
