Friday, February 22, 2008

Free Lunch

In a conversation today about the auction rate market, a friend (who I'll refer to as The Economics Babe) made the observation that people really never seem to learn that there is no such thing as a free lunch. The auction rate market was full of free lunches as long as they lasted. Now that lunch carries a cost which The Economics Babe and I agree will be borne by all the parties involved.

The auction rate market looked like a good deal for everyone involved but especially the broker-dealers. This was not a true market. The broker-dealers who acted as underwriters were allowed to operate with little disclosure (via Bloomberg):

Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.

Inadequate disclosure ``may have masked the impact of broker-dealer bidding on rates and liquidity,'' Martha Haines, head of the Securities and Exchange Commission's municipal office, said in an interview. ``The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.'' ....Along the way, New York-based Lehman Brothers Holdings Inc. was fined $850,000 in 1995 by the SEC for manipulating auctions conducted for American Express. Almost two years ago, 15 securities firms paid the SEC $13 million to settle claims of bid-rigging in auction-rate bonds. The banks neither admitted nor denied wrongdoing.

As usual, the brokers are the ones who benefited the most. The underwriters told issuers they could have a free lunch - long term bonds issued at the short term rate. Then they made sure they continued to collect those underwriting fees by propping up the market when there weren't enough bidders. Then they told individual registered reps they could have a free lunch too. If they sold auction rates as a money market alternative, they could get paid on cash balances that would have paid them next to nothing sitting in money market funds. Finally, clients were told they could have a free lunch by getting a higher rate than a money market with only slightly less liquidity.

In the end, all parties get what they deserve because of their greed. The underwriters will lose a steady source of income. The broker-dealers will get formal complaints when clients can't access money they need for other purposes. Brokers will be further penalized, probably by the SEC, for not properly explaining the risks of this "market". The clients will pay when they have to borrow to fund obligations for which the auction rate money was intended. The issuers (and taxpayers in some cases) will feel the pain in the form of higher rates, at least until they can refinance.

I suspect the issuers will actually pay twice. The part of the market that is failing badly now is the auction rate preferred market where leveraged muni funds borrow to purchase more bonds and pump up their dividends. If that market continues to fail, those leveraged funds may be forced to sell bonds into the same market where the issuers are trying to refinance. And that will mean higher rates than otherwise would have prevailed. Taxpayers lose again.

The lesson many people will learn from this is that Wall Street needs more regulation. That is the wrong lesson to learn. The market punishes those who forget the basic laws of economics. As the Economics Babe said this morning, "No Free Lunch", is the second thing you learn in Econ 101. There are inevitable tradeoffs in economics and if it seems like you are getting a deal too good to be true, you are probably right. All the players in this saga forgot that most basic of economic truths - and they should pay the price.

P.S. There were rumors in the market today about a potential bailout of the auction rate market. The details were murky, but if the Feds step into this market, an opportunity for everyone to learn a basic economics lesson (something that is sorely needed in this country) will be lost. A much better solution is to simply let the market work; something our politicians can't seem to bring themselves to do.

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