The credit crisis ushered in by the collapse of the market for subprime-mortgage-backed securities continues to spread through the debt markets. The latest victim: auction rate securities. Bloomberg reports that, on the heels of unsuccessful auctions of student loan-backed securities last week, auctions have now failed on over $100 million in bonds sold by the Port Authority of New York and New Jersey, Presbyterian Healthcare in Albuquerque and the New York Metropolitan Transportation Authority. In the wake of the Port Authority failure, Bloomberg reports that interest rates on the bonds went from 4.3% last week to 20% percent as of February 12.
An auction rate security is a debt instrument (such as corporate or municipal bonds) whose interest rate is reset through an auction in which the auctioneer begins with a high bid price and lowers that price until a bidder is willing to accept that price or the price falls below a pre-determined reserve price set by the seller (a "dutch auction"). Auctions for auction rate securities are typically held every 7, 28, or 35 days and interest on the securities is paid at the end of each auction period. If not enough buyers are found to buy the securities at prices above the seller's reserve price, the auction fails and the securities revert back to the holders.
As to the cause of the recent auction failures, most commentators, including Bloomberg, attribute the decline in investor demand to three factors: (1) a lack of confidence in bonds themselves; (2) concern over the credit strength of monoline bond insurers; and (3) the related hesitance of broker-dealers to provide active secondary bids.
Regardless of the cause, the continued blossoming of the credit crisis should be of significant interest to insurers and reinsurers because failures in other areas of the debt markets could potentially to lead to D&O and E&O claims similar to those seen in connection with the subprime mortgage crisis.
We will continue to monitor developments related to the subprime mortgage/credit crisis and provide updates at InsureReinsure.com.