Taxpayers On The Hook For Hundreds Of Millions For Auction Rate Securities

We may have just discovered the best business model on Wall Street. State and local governments will spend about $211 in fees paid to investment banks that underwrote auction rate securities—even though the auctions are no longer happening.

Great work if you can get it. It’s basically free money.

Issuers of auction rate securities are charged an annual fee of 0.25 per cent on the now frozen securities. About $84.5 billion of auction rate securities issued by state and local governments are outstanding, according to a report from Bloomberg. Those fees are due even if the auctions fail, which they have been doing consistently for a year now.

From Bloomberg:

Taxpayers continue paying fees to investment banks for the 80 per cent of auctions still failing more than a year after the collapse of the market. In February 2008, the banks that supported the market for 20 years abruptly pulled out, sending interest costs as high as 20 per cent. Local governments aren’t demanding that fees be eliminated, even though they face a cumulative $47.4 billion budget deficit this fiscal year before receiving federal stimulus funds, the Denver-based National Conference of State Legislatures estimated last month.

“Fees are going to continue until we find a permanent solution,” said Whit Kling, director of the Louisiana Bond Commission.

The interest rates on the securities has tumbled, however, as efforts to restore stability to the credit markets has brought down money market rates. The average seven-day rate is 1.4 per cent, down from almost 7 per cent in February 2007. Some of the highest interest rate securities have been refinanced with other debt.

Investors—many of whom are still stuck holding the frozen securities—are markedly less angry about the situation. Even those who are receiving low interest payments are doing far better than investors in almost any other class of assets. The auction rate securities may have saved them from losing far more.

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