More Assets Frozen at Big Banks

Since my column last week, I've received a wave of comments from outraged investors who were sold tax-free auction rate preferred shares as a cash alternative: small-business owners who now can't make a payroll; prospective home buyers who can't complete a purchase; taxpayers who can't access the money they'll need on April 15; stock investors who'd like to take advantage of the market's downturn but can't — all because their supposedly liquid assets are frozen.

Last week the market for variable rate municipal bonds also seized up. These are long-term municipal bonds sold at rates that are set at auction, usually weekly. These trade as individual bonds, rather than as shares in a closed-end fund like ARPS. As such, they have remained somewhat more liquid than the funds, but now that liquidity, too, seems to be drying up.

Last week hedge funds exacerbated the situation when they had to dump portfolios of municipal bonds on the market, depressing prices. Apparently many were short long-term U.S. Treasurys and were long short-term municipals. With warning signs of higher inflation showing up everywhere, something likely to drive up longer-term Treasury rates, and short-term rates being cut by the Federal Reserve, this strategy seemed logical. But in the current market environment, logic seems to have lost its predictive value. These markets moved in the opposite direction, forcing the hedge funds to meet margin calls on their short positions in Treasurys by dumping municipal bonds.

The ARPS I wrote about last week constitute an estimated $330 billion market. Variable rate municipals are an estimated $500 billion market. In other words, we're getting close to a $1 trillion crisis. Yet I don't hear anyone in Congress, the Treasury or the Federal Reserve offering any explanations or proposed solutions. The silence from Wall Street firms, which created these vehicles and vigorously promoted them to issuers and investors alike while earning enormous profits on them, remains deafening. Fortunately many state and municipal officials are starting to speak out and demand some relief from exorbitant interest rates that will eventually come out of taxpayers' pockets.

So far no one from any of the big Wall Street firms that sold these vehicles as cash alternatives has been willing speak candidly to me for quotation about this mess, but one executive, who requested anonymity, did offer these thoughts: "This is a 100-year flood. We had 20 years of liquidity in these auction markets. Now there's a panic. The banks have been beaten up. We can't let anything illiquid get on our balance sheets or we'll face another write-down. Nobody is happy. Eventually there will be a solution, but it will take time. Somebody needs to step up."