walkitout (walkitout) wrote,

Auction Rates, Still More

This is probably the third entry; if you haven't seen me whinge on about this, some were friends-only.
This one, however, is going to be public.

As regular flist readers whose eyes do not totally glaze over when confronted by terms like "auction rates"
know, I got nailed the the auction rate liquidity crisis. A summary for those catching up:

Many/most brokerage houses offered their wealthier clients access to the "reset" market, aka auction rates. These are bonds on which the rate is reset frequently at auctions which are managed by the brokerage houses collectively. Earlier this year, these markets started failing, which hadn't happened in a couple decades or more. Because these things sold frequently, had a higher interest rate than money funds, were generally high quality securities and were typically insured through bond insurers to be triple A, the brokerage houses marketed these securities as "cash alternatives". They didn't even bother to send prospectuses out with them, they were considered that much of a sure thing.

Recently, I realized that (a) my auction rates had not sold yet (UBS and other houses were trying to get their clients out of these in the auctions that were succeeding) and (b) furthermore weren't paying any interest any more. While I like my broker, he didn't seem to understand _why_ they weren't paying any interest, which gnawed at me until I asked a broker (an unexpected benefit of having two) over at Citigroup/Smith-Barney. He, also didn't know why, but with CUSIP in hand, he found out. Here's the summary, NOT specific to this security, but perhaps not applicable to all auction rates.

There are two formulas in the underlying paperwork governing these securities. One is the Max Penalty Rate, set typically at 90 day T-bills + a spread. The other is the Net Loan Rate, which is based on comparable auctions which have succeeded recently. If B < A, the interest is set by B. Banks typically tried to sneak up to as close as they could to the Max Penalty Rate without hitting it, to maximize how much interest they get. But if A < B (and possibly some other criterion as well, like repeated auction failure -- that bit is less clear to me), then the effective interest rate is _NOT_ the Max Penalty Rate, but rather zero. What this adds up to is that It's All the Fed's Fault (not really, I'm exaggerating), and the Fed can make auctions fail more or less at will by dropping the rate on the 90 day T-bill.

Why would the Fed do this?

Well, to encourage banks to borrow money so they can loan money so they can end the _rest_ of the liquidity crisis.

Fun. If you understand this area and spot an error in the above analysis, I _want to know_! Or even just a missed point.

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