Misery acquaints a man with strange bedfellows.—Shakespeare, “The Tempest”

Auction-rate securities were one of the great inventions of modern banking. By taking long-term bonds and putting them together into a stew, the banks made short-term instruments with better yields than cash. The key to the market for such things is that it was liquid, trading regularly from 1985 until early this year. If some auction-rates were not sold in one exchange, they were held by banks and sold at the next.

The system had a symmetric perfection until bank executives decided they did not want the risk of the overflow on their books, even for short a time. The auction-rate market stopped trading and those “cash-like” instruments could no longer be redeemed. Personal investors and corporations panicked. They could no longer sell something they relied upon for quick capital.

Regulators and customers now claim that the banks told buyers that the auction-rate market would never break down. It would trade forever. The risks of putting money into the system were not even modest. They simply did not exist.

As has been true with most riskless investments over time, something went wrong. A $360 billion pool of capital locked up.

At the heart of claims of fault is this notion that banks bald-facedly misdirected their customers, knowing all along that there were flaws in their claims. The market could seize-up at any moment and the financial companies knew it.

Banks bought some of their own false message, buying some of the paper for themselves.

Citigroup (C)is now about to settle with New York State and the feds over these claims that it lied and deceived. It will have to buy back huge amounts of the instruments from its customers and probably pay a fine. According to The Wall Street Journal, the sum of the problem is that “the firm could be forced to spend more than $5 billion to buy out individuals.” Since the paper is worth 70% or 80% of face value, Citi’s write-down could be $1 billion

In effect, Citigroup is cutting off the only line of defense that its fellow banks and brokerage firms had. They have claimed that everyone knew the risks and that the sellers are blameless. The “fine print” on the auction-rate agreement spelled out the terribly consequences of market illiquidity

.Now that Citi is preparing to settle, the walls of protection from customer claims in other parts of the industry have been breached. That raises the value of problem up to some portion of the $360 billion value of the market. A small portion of these bonds have been sold, but it would not be unwise to guess that banks could face several billion dollars in write-downs, adding further to the capital problems within the industry.

Write-downs mean raising more capital, which tends to move in the direction of having to raise more money.

The trend is that there will be more pressure on bank shares and this will make it worse.

Douglas A. McIntyre

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