A painful fix for the credit crisis

An ultimatum

The final result was the debt-market equivalent of a run on the bank. Beginning Jan. 22 and continuing through the second week of February, such "fly by night" borrowers as the Port Authority of New York and New Jersey, the University of Pittsburgh Medical Center and Nevada Power took billions in debt to one of the periodic auctions that sets a new floating interest rate for these issues and saw 80% of the deals fail to find a bid.

To make matters worse, the big banks that make this auction market for municipal-debt issues declined to make a market by buying this debt themselves. Their balance sheets were already stretched thin by their own problems, and they couldn't afford to take on any more risky paper.

Essentially, buyers had lost confidence, and the market had shut down. On one day, Feb. 13, 129 auctions failed. Interest rates automatically climb after a failed auction, so a low-risk borrower like the University of Pittsburgh Medical Center is looking at its interest rate climbing from 3.5% to 10% and as much as 17%.

But the failed auction and the shutdown of a $300 billion hunk of the municipal-debt market finally spurred government into action, although not the government in Washington. New York Gov. Eliot Spitzer and Insurance Superintendent Eric Dinallo, who have just a bit of clout because the country's biggest financial markets are in their state, gave the insurance companies an ultimatum Feb. 15:

Fix the problem by raising enough money to preserve your AAA ratings and restore confidence in the municipal market or face action that would break the companies into two pieces. One piece, the "good" company, would keep the portfolio of low-risk insurance for the municipal market. The other piece, the "bad" company, would get the high-risk paper.

Banks launch counterattack

The banks hate this idea. It would leave all the risky paper in their portfolios insured by the bad company. Ratings and prices for this debt would plunge. So it's not a surprise that big banks have been trying to hammer out a $15 billion bailout for the insurers. No one is sure if they'll get the deed done or if $15 billion is enough.

The banks also have launched a counterattack on the Spitzer-Dinallo effort, saying it's doomed because the complexities of who owns what debt and who should pay what costs would take years to unravel in court.

I think that's probably true but largely irrelevant. No owner of any of these debt securities would want to remain illiquid while the courts slowly crept toward some ruling and then heard appeals on what these debt instruments were worth. The smart thing to do, if this plan has any chance of moving forward, is to sell.

And that's just what banks and other holders of the least risky of this risky paper have been doing. Not in the open market. There, buyers remain resolutely on strike; they're not going back into the market until they know the "run on the bank" is over and their money will be safe tomorrow.

The Fed to the rescue

Fortunately for the folks who run for-profit banks, there's always the U.S. Federal Reserve. That bank opened a new window Dec. 12 called the Term Auction Facility that accepts "damaged" assets as collateral for new loans. The Fed will take the paper that no one else wants to buy because they rightly don't have any faith in its value, and in return it will issue nice, new, full faith and credit of the United States of America dollar bills.

So far the banks have borrowed $50 billion from the Fed this way.

Right now it looks like -- I dearly hope I'm right -- the state of New York, the Federal Reserve and private "vulture" investors have combined, perhaps without any conscious planning, to create a classic carrot-and-stick resolution to the debt-market crisis, one that would clear out all the debt that no one trusts and push a giant reset button for the markets.

The stick is the threat to destroy the ratings in the riskiest part of the debt markets by breaking the debt insurers into two parts and sticking the weaker part with the riskiest debt.

The carrot is a chance to sell parts of that risky portfolio to the Fed and to private investors who are willing to buy if the price is right. The write-offs from that are likely to be considerable -- anywhere from $50 billion to $125 billion more than the considerable amount that's been written off so far.

That doesn't seem like much of a carrot until you remember that estimates of total write-offs have climbed to $400 billion. Makes $50 billion seem like a real bargain, no?

Continued: Developments on past columns

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