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Commentary: It’s Time for a 'Big Bucket’ to Calm the Auction-Rate Market

Get your buckets ready, it’s time for a bailout in the municipal market.

Recovering from the auction-rate securities liquidity crisis will take some time, but to do it in an orderly way, the auction market needs to begin functioning again.

The most obvious way for that to happen is for a major buyer — ideally the Federal Reserve or U.S. Treasury, although a coalition of state treasury and pension-fund managers might also be effective — to intervene and begin purchasing municipal auction-rate deals.

These “emergency buyers” can set standards for their participation — a Libor-linked minimum rate at which they’d bid, and a set time period, say one year, for their intervention. Regardless of the details and who actually does the buying, the objective will be clear: creating short-term stability that will allow municipal issuers to restructure their debt into alternative structures without further damage.

While more auctions cleared last week than two weeks ago, we shouldn’t take that as a sign the crisis is over. Instead, issuers found themselves “defining deviancy downward,” to quote the late Sen. Daniel Patrick Moynihan. While the Port Authority of New York and New Jersey was clearly relieved that it did not suffer a second consecutive failed auction of its seven-day paper — the first failure sent its interest rate soaring to 20% — the fact that it’s still paying an 8% interest rate should bring comfort to no one, except the vulture investors who knew a deal when they saw it and stepped in to clear the market.

The muni market didn’t create this crisis — it’s yet another spillover impact from the subprime mortgage lending debacle — but forcing municipal issuers in failed auctions to pay obscene “penalty rates” for an extended period will quickly make it worse, as interest costs exceed budgets and threaten issuers’ still-sterling underlying credit quality.

None of the usual free-market arguments against government intervention apply here. In contrast to other rescue plans, most notably the Treasury’s failed super-SIV initiative late last year, there is little risk of “moral hazard” or throwing good money after bad.

On the moral hazard front, the events that led to the seizure in the ARS market are extraordinary and issuers should not be punished for failing to anticipate them. In fact, the current crisis casts a new, harsher light on the Securities and Exchange Commission’s investigation into the auction-rate market more than a year ago. The SEC alleged that major broker-dealers frequently stepped in to clear auctions, allowing them to downplay the risk of a failed auction — exactly the risk that turned out to be painfully relevant now. It’s reasonable to assume that municipal ARS volume would have been significantly lower over the last five years if issuers knew how often broker-dealers had been called upon to use their own capital to “save” auctions.

Meanwhile, the emergency buyers will receive attractive rates on secure assets and investors will receive their cash back at par — not unreasonable for an underlying asset whose credit quality is unimpaired.

In fact, the buyers may never end up owning any municipal auction-rate securities; their mere presence in the background could be enough to repair private investors’ damaged psyches and get the market moving again. Corporations and wealthy individuals originally entered this asset class as a cash equivalent, and liquidity is paramount — when it was threatened, they stormed for the exits. Now, knowing that there is a deep-pocketed “buyer of last resort” ready to clear auctions if they ever need to cash in, those investors are just as likely to flock back in.

And this bailout is not just a matter of delaying the day of reckoning. With a little breathing room, issuers can be relied upon to put in place permanent solutions, either by changing the deals’ mode or structure.

The long-term municipal market continues to function well, and money-market fund demand for high-rated securities is unbowed. Some triple-A insurers’ ratings remain untarnished, and new entrants like Berkshire Hathaway and perhaps others are waiting in the wings to provide capacity to the market.

But issuers need time for those options to mature and to physically execute the restructurings. No one’s dragging their feet: The Bond Buyer has been filled with reports on issuers’ strategies for refunding their ARS, but there are only so many professionals — and so many liquidity facilities — to go around.

Especially given that many ARS are integrated with swaps to create synthetic fixed-rate structures, and that the most popular alternative seems to be refinancing with long-term debt, it’s in everyone’s interest to make sure the issuers and their financial professionals have enough time to think through all the consequences.

Last week, New York Times columnist Paul Krugman cited the municipal auction-rate securities crisis as a test of investors’ faith in the global financial system, observing that a “loss of trust can become a self-fulfilling prophesy.”

The Princeton economics professor’s observation is in line with economic teachings. But it’s time to throw out the textbook. The regulators have a great chance to make a successful stand in this corner of the global financial markets, and that win could start to restore faith and become its own self-fulfilling prophesy. “What market is next?” Krugman asks. With a well-designed intervention, the answer can be: “The buck stops here.”

Tell us what you think. Share your comments on this issue at The Bond Blogger at blog.bondbuyer.com

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