We cringe when we hear the guests on bubble TV claim that the credit crisis is almost over and that it has been exaggerated by fear-mongers. In reality the credit crisis is getting worse and spreading to as yet unknown areas. Each week seems to bring a new surprise that reveals an unexpected financial event and some new acronym for a security that few have ever heard of before. At first it was RMBS, CDO, CDO squared, SIV, ABCP and CLO. Now it’s TOB, VRDO, ARS, LevX and LCDY. Each revelation leads to new concerns, exposes new victims, creates the potential of even more writedowns and leaves everyone wondering where the next surprise is coming from.
As it turns out this week’s new problem are auction-rate securities (ARS), an obscure but important segment of the credit market. ARS are basically long-term debt that has been considered to be liquid since they are auctioned every week with the interest rate reset to current conditions. ARS comprise a $360 billion market of securities issued by municipalities, student-loan authorities, museums and many other entities. As a result of recent turmoil in the credit market, investors have largely withdrawn from the weekly auctions, causing the interest rate on the securities to soar. The major problem is that a lot of the ARS are insured by the troubled monoline insurers. In addition it is highly likely that a large number of investors are just avoiding complex securities that are not well understood, and are gravitating to more basic investments.
As a result of the turmoil, what was viewed as a highly-liquid instrument is turning out to be difficult to sell, and over $10 billion of ARS have been frozen including borrowings for Deerfield Academy, Carnegie Hall and De Young Museum. In addition the Michigan Higher Education student Loan Authority had to stop making student loans, affecting more than 100 Michigan colleges and universities. The Port Authority of New York and New Jersey found its interest rate jumping to 20% from 4.2% the prior week. Corporations, too, are major holders of these instruments. US Airways stated that the airline’s cash fund held $411 million ARS that failed to settle at auctions. Importantly, the ARS are yet another off-balance sheet asset of the banks that they may have to shift onto their books.
At the same time the monoline insurers are not out of the woods. Today, Moody’s cut the rating of FGIC by six levels from Aaa to A3, and said they may have to cut again. FGIC is the 4th largest monoline, and their rating was cut by Fitch last month. The ratings agency said that FGIC was $4 billion short of the amount of capital needed to justify an Aaa rating. Moody’s indicated that their assessment of MBIA and Ambac would probably be complete in the next few weeks. New York governor Eliot Spitzer today gave the leading monolines 3-to-5 days to come up with capital or face a breakup by state regulators. This would essentially strip them of their safe and profitable municipal bond insurance business and leave them with the toxic structured finance mess.
The subprime turmoil is still with us as well and, ominously, is not confined there. At a press conference yesterday Treasury Secretary Paulson said that in terms of subprime and resets, "The worst isn’t over, the worst is just beginning". According to the Mortgage Bankers Association the default on ALL outstanding home loans is 7.3%, the highest since records began being kept in the 1970s. Even the rate on prime loans has climbed to 4%.
Moreover, we are now seeing substantially higher default rates on credit card, auto loans and student loans. It doesn’t promise to get any better, and despite significant Fed ease, credit is actually getting tighter. Over the last six months there has been a sharp decline in the willingness of banks to make consumer installment loans. The percentage of banks tightening lending standards on business loans has also risen substantially. Mortgage loan standards have been tightened. The interest rate on bank loans has been going up while the cost of their funds has been dropping. All in all both the cost and availibility of funds has tightened. This creates a substantial headwind against an economy that is either already in recession or on the brink. In our view the dire credit situation is causing a major unwinding of debt that is always deflationary. As we head further into recession inflation, which is a lagging indicator, will become less of a concern while deflation will come to be seen as the greater threat.
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