Auction Rate Securities

Rate hikes
The Port Authority of New York and New Jersey's interest rate jumped Tuesday to 20% from about 4.2% when bidders didn't show up at an auction of its securities by Goldman Sachs Group Inc.

ARS
The auction-rate securities are essentially long-term debt, but investors treat them like a liquid, short-term holding because of the auctions. The problem is that investors have balked at the auctions lately, sending interest rates on these securities on a wild ride.

Factors
Several factors are behind these auction failures. Many of the auction-rate securities are insured by troubled bond insurers, like Ambac Financial Group Inc. and MBIA Inc. The bond insurers face billions of dollars in potential claims because of exposure to subprime mortgage debt. Investors are worried that might jeopardize the other policies the companies have written. MBIA backs the Port Authority's debt.

More broadly, the credit crisis has many investors wary of instruments with complex structures. In their search for holdings that are simple and straightforward, they're diving into Treasury securities and shifting away from products such as auction-rate securities.

Beyond driving up the costs for borrowers such as the Port Authority, disruptions in the market are a potential problem for holders of these securities, many of whom bought the instruments thinking they could be sold easily. They are finding that they might be stuck with these instruments longer than planned.

Banks Unwiling to Step in
In less tumultuous times, the banks might be expected to step in and buy some of these securities themselves to help smooth the process. But their balance sheets are already stuffed with other holdings -- loans to corporate borrowers, lines of credit to customers, mortgage debt and more -- so they have decided not to intervene in this market.

As a result, well over $10 billion worth of auction-rate securities have been frozen. These included borrowings for Massachusetts prep school Deerfield Academy, Carnegie Hall and California's De Young Museum, among many others.

On-Balance Sheet for Some Banks
The debt instruments don't show up as assets because the entities that issue them qualify to be kept off the banks' books. There is a catch: If there aren't any buyers when the debts roll over, the bank sponsoring the bonds may have to step up and essentially buy them due to what is called a liquidity backstop agreement.

That isn't likely to lead to losses because municipal bonds tend to be high-quality, but it would take up capacity on their balance sheets. According to third-quarter 2007 securities filings, Merrill said it could be on the hook for nearly $40 billion. Citigroup had pledged to provide up to $26 billion in such liquidity, and J.P. Morgan said it could be obligated to fund $17.5 billion of such debt.