Question Regarding Wall Street Journal Piece “Firms Fight Banks Over Billions in Frozen Notes”
The article speaks to the billions in frozen auction-rate securities and how 400 companies sank their cash into the investments thinking they were liquid. From what I get, in the end, Wall Street firms were forced to pay back individual investors but not companies. Could anyone elaborate on the article and just what auction-rate securities are?
These are essentially 20-year bonds. The buyers of these securities lent money to the sellers, which the article indicates were mostly municipalities and charities. The interest rates on long-term loans are generally higher than those for short-term loans. This is known as a positive yield curve. If you go into any bank branch, you’ll probably find a sign listing the interest rates that they offer on various certificates of deposit (CDs). The rates for the 1-month CDs will usually be lower than those for the 1-year CDs, which will be lower than those for the 3-year CDs.
The buyers of the auction-rate securities wanted to receive the higher interest of lending over a longer term but also wanted to have their money available whenever they wanted it. The banks offered these securities that would supposedly let them do this. If the buyer decided that it wanted its money, it would simply auction the loan off. If long-term interest rates had stayed the same or gone down, this would have worked.
What happened instead is that long-term interest rates went up. No one wants to buy an existing $100 loan that has an interest rate of 7% for $100 when they can make a new $100 loan with an interest rate of 10%. Instead, they will pay just enough for the old loan so that it will yield 10% (in this example, about $80).
Once again, someone was trying to get something for nothing and, once again, they got burned.
Doug, TY for a very enlightening post