Felix Salmon

Do auction-rate securities have a future? I’m not sure myself, so I put a couple of questions to Floyd

Newton, a partner in King & Spalding’s finance practice. Floyd has a long history in the auction-rate market, and seems to know what he’s talking about.

My first question was whether the new electronic trading platform being launched by Restricted Stock Partners is likely to help bring liquidity back to the market. Floyd says no:

I do not believe that this imitative will have any affect on the

secondary market for auction-rate securities. These securities are

readily available from the existing broker-dealers, and I am not aware

of any reason why having an electronic trading platform from this

company would have a positive impact on this market. The principal

issues in this market are simply a lack of investor confidence in this

market. When auctions begin to fail, for whatever reason, it creates a "panic" where investors rush to get out unless the broker-dealers act to

stabilize the market, and at the present, they are not able to do this.

My second question was whether John Carney is right when he says that auction-rate securities never had much of a market to begin with, and were always supported by the broker-dealers. Floyd’s unsure about that as well:

This is a more complicated question. First, I am not sure that I agree

that the auction market "never had enough buyer demand" to support

itself. I doubt that this market would have gotten to this size if

there were not buyers out there demanding this product, at least until

they became concerned about their liquidity. Stabilization is a

different issue. There is nothing wrong with stabilization to protect

the market and produce more uniform results. Where the buyers lose

confidence in the market in a short time period and there is a "rush" to

the door by the investors, it is not surprising that the broker-dealers

are not willing to "stabilize" the market.

Going forward, I suspect that this market will not exist in its present

form. Investors in this type of security are very concerned about their

liquidity, and with the liquidity of these investments now in question,

it is unlikely that they will return in volumes needed to support this

market.

Overall, then, it seems that the market used to be healthy, once upon a time, but that it’s now a thing of the past – and nothing, not even a swanky new electronic trading platform, is likely to save it.

Credit ratings wonks will love the detail in Christopher Whalen’s interview with Drexel University’s Joseph Mason today. But my favorite bit is a remark near the beginning:

Mason: I have been meeting with some large pension funds outside the US, large state run pension plans with a lot of exposure and a lot of losses. As a group these funds are very angry at the inaction by the Congress, which held a few hearings last year but then followed up with absolutely nothing. Congress’s treatment has been to wait and see if this crisis clears up because dealing with it directly is going to be very difficult.

Whalen: Well, to be fair, there is no one to talk to on Capitol Hill today, is there? Can you even think of a single member of either house who really understands finance well enough to investigate this mess?

Mason: No, none of them understand it. They understand that the problems are really big. But in a way, the congressional hearings last fall worked to the advantage of the ratings agencies. They called the legislators’ bluff. They said, "This is so big, you figure out how to fix it." When legislators didn’t know how they decided to wait and see if the crisis would blow over.

The ratings agencies have done very well out of the status quo, even as investors – and municipalities – have suffered. They’re never going to be the agents of change, and Congress isn’t going to change anything either. Which is probably one reason why Warren Buffett is perfectly happy holding on to his 19% stake in Moody’s.

The NYT does a very good job of moving the municipal bond ratings story forwards this morning – and making it the newspaper’s lead story, no less. One thing it does is answer my question for John Carney and provide the name of a municipal bond investor who defends the current system. But much more importantly, the story opens up a huge gulf between Moody’s, on the one hand, and S&P, on the other.

The investor, first:

“If you rate 95 percent of the issues the same, the ratings cease to be useful, and investors need and utilize these ratings to differentiate credits,” said John Miller, chief investment officer at Nuveen Asset Management in Chicago, which manages about $65 billion in mostly tax-exempt bonds.

I don’t buy this argument at all. Firstly, no one is suggesting that 95% of municipal bonds should be AAA-rated. Maybe two-thirds. More to the point, it’s the present system which gives everything the same AAA rating, by forcing municipalities to buy monoline wraps. If you want a system where 95% of the bonds have a AAA rating, just keep the status quo.

As for differentiating credits, I still don’t see why tiny differences which would be comfortably absorbed within the AAA range were they in the corporate arena suddenly become hugely important when they’re in the municipal arena.

But the part of the article which jumped out at me was this, from S&P:

Executives at S.& P., however, say they use a single global rating scale to measure all kinds of debt. Colleen Woodell, chief quality officer for public finance, acknowledged that municipal debt had defaulted at lower rates than corporate issues, but she noted that the data covered a relatively benign 20-year period.

A single global rating scale. This only goes to prove that either S&P or Moody’s is rating municipal bonds incorrectly:

Gail Sussman, the Moody’s executive in charge of public finance ratings, likened the firm’s dual ratings scale to a ruler that measures in inches on one side and centimeters on the other.

S&P and Moody’s generally rate municipalities identically. Since S&P uses a single rating scale and Moody’s uses two different scales, there’s a massive discrepancy here. And Gail Sussman doesn’t help her cause much at the end of the article:

Ms. Sussman, of Moody’s, said the firm would be wary about adding qualifiers to triple-A ratings, which the company regards as “gilt-edged.”

If triple-A ratings are really "gilt-edged", then Moody’s shouldn’t be giving them out willy-nilly to corporate and structured bonds. The damage to AAA’s gilt-edged reputation has already been done, as any holder of AAA-rated subprime bonds will tell you.

It would be consistent – and honest – for Moody’s to refuse to upgrade municipal bonds on the grounds that it had made some big mistakes on the corporate and structured bond front for many years, and that it didn’t want to further sully AAA’s reputation. But its actual position just comes across as slippery.