Auction Rate Securities: Who is to Blame?

New York Attorney General Andrew Cuomo continues on the crusade of his predecessor, former Governor Eliot Spitzer, even though the prosecution of Wall Street investment banks threatens the vibrancy of the New York economy and complicates attempts to restore liquidity to the mortgage and credit markets. The newest focus of Mr. Cuomo’s litigation is the investment banks that were involved in the auction rate securities (ARS) market. Auction rate securities are generally long term debt instruments with variable interest rates that reset periodically. On daily, weekly, or monthly reset dates, an auction is held where investors can bid to purchase securities or offer their holdings for sale. Supply and demand establish a market clearing interest rate enabling ARS to trade at par. As the grasp of the credit crunch slowly choked the life out of the investment banks, they abruptly withdrew their liquidity bid that had maintained order in auctions that are often characterized by low volume and order imbalances. Without an independent liquidity provider ensuring balance between buy and sell orders, dramatic seizures in the auction rate securities market ensued, entrapping investors in illiquid securities that often have provisions capping interest rates in the event of auction failures.

Auction rate securities, on their face, are a valuable financial innovation that has enabled borrowers to secure long term financing for lower short term rates. They have funded municipalities and infrastructure projects for decades, providing investors with compelling yields on money market instruments. In order to boost underwriting fees, the investment banks issued ARS as financing for closed end mutual funds and other investment pools. These securities contain complicated formulas that limit changes in the interest rate when an auction fails, effectively disrupting the market clearing mechanism that enables these securities to trade at par. The investment banks were forced to provide liquidity bids and acquire significant quantities of these ARS in order to ensure that the auctions for these poorly structured securities did not fail. Culpability was established once Mr. Cuomo uncovered a concerted effort by the banks to sell these securities to unsuspecting clients prior to withdrawing their liquidity bid, ultimately eliminating investors’ ability to liquidate securities that were advertised as cash equivalents.

The creativity of the U.S. financial system leads to market innovations that enable our economy to thrive, but also permits moral hazard to threaten the stability of our markets. Unfortunately, the investment banks have once again demonstrated a dearth of morals and fiduciary responsibility in their quest for personal riches. Their actions have undermined products that have increased capital market efficiency and provided financing to municipalities for decades. By marketing securities containing provisions that virtually guaranteed illiquidity to naïve clients, the investment banks caused widespread failures across the auction rate securities market and subjected many issuers to millions in additional interest expense. Akin to their reckless securitization of risky tranches of collateralized mortgage obligations (CMOs) and other toxic debt into collateralized debt obligations (CDOs), the investment banks have jeopardized the viability of broad asset classes that formerly provided essential liquidity to the U.S. economy. Unlike the mortgage and CDO markets, it was the interest rate caps and convoluted reset formulas that eroded liquidity in the ARS market rather than the quality of the underlying assets. Regardless, the investment banks’ pervasive abrogation of their fiduciary responsibilities and unrestrained pursuit of underwriting fees and trading profits has caused immeasurable damage to the U.S. economy and threatened the financial future of countless Americans.

The Erosion of the Capitalist Ideal

The rapid growth of the Chinese economy leaves most Americans feeling a little envious. With the U.S. economy limping along under the weight of the housing bubble and the deleveraging of global financial institutions, one cannot help but marvel at the economic growth that has propelled the Chinese economy to new heights while enriching the nation and its people. The policies of the Chinese government have often elicited disapproval from political leaders in the U.S., but their version of capitalism has enabled rapid growth by squashing the dissent that can delay or derail that which is in the best interest of the majority. Concurrently, the United States has grown complacent in its role as economic superpower, diverting its collective focus from growth and innovation to litigation, regulation, and special interest handouts.

Comparing China and the United States leads to a tale of two distinct philosophies. While embracing tenants of capitalism, China maintains significant government control and ownership of key industries leading to centrally planned growth driven by the strategic planning of party leaders. Chinese leaders manage economic growth and investment in a strategic manner that attempts to sustain economic growth and the development of infant industries while encouraging foreign investment and cooperation. The United States, on the other hand, has drifted slowly from the ideal capitalist economy towards a bastardization of French socialism. Government bailouts, a paternalistic tax code, nationalized industries, and political support for a welfare state have gained prominence in the public psyche. The ability of the Chinese, for better or worse, to quash dissent and act as a coordinated whole has led to dramatic growth while the United States dissolves into competing factions that quest to secure their scrap of the next government handout.

The U.S. economy will continue to flail and hemorrhage until the U.S. citizenry rebukes efforts, spearheaded primarily by prominent Democrats, to create a welfare state financed by a dangerous scheme of income redistribution. When the government well finally runs dry, the predatory scavengers that picked clean the bones of the U.S. economy will be left in complete befuddlement as they ponder how taxes on the “wealthy” could fail to provide for their every need and fancy. Just as the rapid economic development of the Chinese has demonstrated, the capitalist ideal promotes the greatest economic benefit for society, but does not ensure equal distribution of the economic gains. The U.S. economy and populace will continue to suffer until its political leaders realize that interfering with the natural allocation of capital and income leads to suboptimal outcomes for all.

A False Sense of Security

The credit market meltdown, a consequence of lax lending standards and easy monetary policy, has led to turbulent markets over the past 18 months while prompting government bailouts and stimulus packages. In each instance, the market reacted positively under the assumption that the government or the Federal Reserve would rescue the ill-fated perpetrators and reckless consumers that precipitated the current crisis. As further losses were inevitably exposed, the market quickly realized that their previous interpretation was overly optimistic and the lows were retested. The federal guarantee of the GSEs has, at least temporarily, stabilized the credit markets and prevented the carnage that would ensue if the largest mortgage liquidity providers became insolvent. Recent strength in the dollar and falling commodity prices could lead one to assume that this rebound has legs. Time, however, will likely refute this conclusion.

A rapidly slowing European economy, driven in part by the efforts of the European Central Bank to curb inflation, has incited recent dollar strength and expectations for lower interest rates in Britain, Australia, and Europe. Concurrently, the slowdown in global economic activity has alleviated much of the supply and demand imbalance in the oil and commodities markets, leading to dramatic price declines that are reducing inflationary pressures. Consumer sentiment, which has a strong inverse relationship with fuel prices, has rebounded slightly as pressures on discretionary income have subsided. The August University of Michigan consumer sentiment index increased slightly to 61.7 from a June low of 56.4. These factors lead bulls to predict an abatement of inflationary forces and a rebound in economic growth in the U.S. While the stock market rebound has conveyed signs of optimism, credit markets continue to price significant uncertainty through higher credit and mortgage spreads and lower treasuries yields

Investment Grade Credit Spreads - 5yr CDX Index (Source: Bloomberg)
(March 10, 2007 high of 192.5 in the midst of the Bear Stearns implosion)

The growing disconnect between credit and equity market expectations suggests that there is significant disagreement about the ability of the bailout packages to address weakness in the housing and mortgage markets. Equity markets, perhaps driven by declining oil prices and strength in the dollar, have rebounded in anticipation of a trough in the current economic slowdown. Credit markets have discounted the effects of the bailout packages and predict a continued lack of liquidity as banks recapitalize. Retail mortgage rates have steadily increased, placing greater pressure on a struggling housing market. Until housing begins to rebound, no amount of bailout or stimulus packages can restore liquidity and stop the hemorrhaging of bank capital. In the mean time, expect further losses and additional bank failures to predominate along with corresponding volatility in the markets. The end, it seems, is yet to come.

Escaping the Burdens of Consumer Debt

As the economy slows and onerous debt hangs ominously over the heads of consumers and corporations, the excesses of the housing boom are a cancer on the U.S. economy that must be cured before recovery can ensue. While banks raise additional capital and reduce credit availability, consumers confront a changing landscape where it is no longer possible to repeatedly consolidate debt in response to excessive consumption. Instead, consumers must face the consequences of their consumption lifestyle and begin to amortize the debt incurred during the glory years of the housing boom. In support of this noble endeavor, some strategies for reducing consumer debt and strengthening one’s financial standing follow.

Distinguish between needs and wants. Perhaps the biggest difference between the chronically indebted and the financial secure consumer is the ability to distinguish between needs and wants. For example, everyone has basic needs such as food, shelter, and clothing, but how these needs are satisfied can greatly contribute to financial independence. Too many consumers satiate their basic needs with products that are premium priced in order to maintain an image of success or alleviate feelings of inadequacy. People burdened with excessive consumer and mortgage debt should consider shopping for clothing at Target as opposed to purchasing the designer wares of Bloomingdales. Similarly, that steak at Ruth’s Chris should be foregone in exchange for a burger at home. When burdened by substantial debt, even smaller purchases such as CDs, a night at the movies, or a Starbucks coffee should be considered unnecessary luxuries.

Many small victories win the war. Dramatic progress can be made towards reducing debt by focusing on the frequent small purchases that are made on a daily basis. By eliminating frequent purchases of luxury items such as the $5 coffee, $8 sandwich for lunch, or even a soda from the vending machine, one can save an incredibly surprising amount of money thereby slowing the accumulation of new debt and facilitating the reduction of existing debt. While it may be less desirable to drink the free coffee in the office or bring a lunch from home, the obligations incurred during previous spending binges dictate that little luxuries must be sacrificed.

Segregate funds and identify savings. In order to instill a sense of discipline, it is important to explicitly segregate funds to ensure that habits of excessive consumption are curtailed. Every day that you sacrifice the morning coffee or lunch out, take a $5 bill and place it in a special envelope or jar. In order to ensure this piggy bank is not raided in a moment of weakness, the dollars collected should be applied towards outstanding debt by making debt payments weekly in addition to the regular monthly payment. Each payment will reduce outstanding principal and expedite the retiring of existing debt.

Focus on high interest revolving debt first. The supplemental debt payments should be applied to debt with the highest interest rates first. In additional, priority should be given to debt with payments that will vary based on outstanding principal balances such as credit cards. By paying down revolving debt, the monthly debt burden will be reduced as the fixed required payments will decline as the principal balance erodes. Ideally, one would continue to make the same monthly payment even if the required payment is reduced, but the lower periodic payment provides greater flexibility in the event unexpected expenses arise.

When you incur excessive debt, you relinquish your right to future consumption in order to satisfy immediate wants. You have no right to the $1200 Marc Jacobs purse or $300 pair of jeans because you sacrificed future consumption in order to finance the widescreen TV, expensive dinner, and vacation that you purchased on credit yesterday. Frequently, the mentality that abundant future income will alleviate the debts of the past leads to crippling debt levels that become onerous in the event of unexpected illness, job loss, or other expenses. Personal responsibility and accountability are often lacking in the U.S., especially given the growing socialization of individual excesses through government bailouts, tax credits, and market interference. The current contraction in credit, however, will hopefully instill a discipline among consumers and lead to the reemergence of the virtues of saving and investing, through which financial independence can be attained.

ESPN X Games 14 Los Angeles

The fourteenth ESPN X Games, a made for TV action sports spectacle, attracted sell out crowds at the Staples Center and Home Depot Center in Los Angeles. Multiple days of BMX, skateboarding, motocross, and rally car engaged action sports fans in the stands and on the TV. Rather than supporting a core set of events, ESPN and sister network ABC constantly attempt to push the boundaries of extreme sports, injecting new formats and events into the lineup in an effort to capture the attention of fickle viewers. This year, ESPN’s plan to drop the skateboarding vert event, which has been a mainstay of the X Games since the maiden event in 1995, almost derailed the entire production.

Rob Darden with big air on his way to SuperPark Bronze.

The X Games sought to eliminate the vert event in favor of a skateboarding “SuperPark” venue that was designed to replicate the pools and concrete skate parks that predominate the sport. The backlash by virtually all of the top competitors, however, promptly induced a reversal by ESPN and the reintroduction of the vert event. In an obvious attempt to undermine the event, ESPN configured a simple “old school” 13-foot vert ramp that was much shorter than last year’s and lacked any special elements. ESPN, obviously favoring the most awe inspiring events like megaramp, seemed intent on limiting the riders’ ability to showcase their talents in order to justify their decision to retire the vert venue. Despite their efforts, all of the top riders participated in the vert event with Shaun White failing to defend his 2007 title as last year’s runner up Pierre Luc Gagnon (PLG) took the gold.

Shuan White Soaring over California in Skateboarding Vert

With the X Games 13 ratings increasing 7% to a total of 38 million viewers, it is both puzzling and obvious why ESPN would attempt to focus on shock value events as opposed to traditional favorites. On the one hand, the new “big air” events attract casual viewers who are entranced by the surreal feats while loyal fans crave the purity and innovation in traditional events. ESPN hopes to attract a broader audience by including novelty events, but they should be careful not to alienate the loyal fan base that supports the action sports industry. Competing tours such as the AST Dew Tour, founded by NBC and sponsored by MTV and Nike, combined with special events such as the Maloof Money Cup, premiering at this year’s Orange County (California) Fair with the largest purse in the history of the skateboarding, are providing leading skaters and BMX riders with attractive alternatives should ESPN and the X Games stray from the core events. Ultimately, ESPN’s attempt at redesigning vert, the aforementioned SuperPark event, failed to attract the top riders who viewed the venue as more suited to BMX. Failure to heed the message of the skaters and the massive crowd of fans that vert is an essential event could signal the demise of the pioneer action sports events, the X Games.

BMX Vert - X Games Fourteen - Los Angeles

Declining Tax Revenues Threaten U.S. Transportation System

The U.S. Federal Highway Administration recently reported that Americans drove 3.7% fewer miles in May 2008 compared to the prior year. As oil prices have rocketed skyward, economic growth has slowed and conservation has increased resulting in consistent declines in year over year vehicle miles driven. The decrease in miles combined with a shift towards more fuel efficient vehicles portends deficits in the U.S. highway trust fund, sending Congress scrambling for funds as infrastructure needs are growing around the country. With gasoline consumption predicted to decline for the first time since 1991, the federal gasoline tax of 18.4 cent per gallon will generate substantially lower revenue despite dramatic increases in fuel costs. The Treasury Department has already reported a $2 billion decline in trust fund receipts through May, leaving Congress with difficult decisions as they develop a new six year $400 billion transportation spending bill.

Many states and municipalities have resorted to private financing to alleviate budget shortfalls or to address transportation funding needs. The Chicago Skyway Bridge and the Indiana Tollway were both leased to Cintra Concesiones de Infraestructuras de Transporte S.A. and Macquarie Infrastructure Group, a consortium that is also developing the Trans-Texas Corridor for the Texas Transportation Commission. These efforts to use private financing for public infrastructure raise concerns that the vast network of roads and highways that enable commerce and mobility will be mortgaged in order to finance current spending on unrelated political priorities. Other efforts by states, such as Pennsylvania, to impose tolls for travel on existing interstate highways may provide alternative funding sources, but are likely to face significant grassroots opposition.

Federal and state leaders have demonstrated a gross inability to plan for long term infrastructure and energy needs. By failing to develop a comprehensive energy plan, Congress has left consumers at the mercy of oil producing nations in the midst of global supply shortages and rising fuel costs. As a result, manufacturers and distributors are beginning to reorganize to reduce transportation costs by locating facilities closer to end users. Consumers have voiced their displeasure by shunning the gas guzzling SUVs of U.S automobile manufacturers in favor of fuel efficient imports, further depressing the domestic manufacturing industry and increasing unemployment. U.S. automobile sales fell to an annualized rate of 13.6 million vehicles, the lowest volume since 1993, leading to plant closures and job cuts at GM, Ford, and Chrysler. As people lose their jobs and reduce discretionary spending, mileage driven will continue to decline as both commercial and personal traffic is curtailed.

The revenue shortfalls constraining transportation spending in the U.S. will certainly be addressed through higher taxes, fees, and tolls which, combined with the high cost of gasoline, will magnify the onerous burden on American motorists. Years of wasteful spending and earmarks for pet projects by the morally bankrupt members of Congress have diverted transportation dollars from critical infrastructure needs, leaving hard working Americans, once again, stuck with the tab.