Another $500 billion market you've never heard of freezes up

Fourteen months ago, I learned about the $330 billion market for a new financial instrument called Auction Rate Securities (ARS) -- bonds sold as cash-like instruments whose yields reset in periodic auctions. But in February 2008, the banks that created ARS stopped propping up the market and people who held these cash-like securities discovered that their ARS had been frozen. Since I first posted about this, 7,988 comments have appeared on the post from people trying to get their money back.

Today, I learned that there is another instrument with an even bigger market that has been suffering the same fate -- Variable Rate Demand Notes (VRDNs) -- which until October 2008 consisted of supposedly low-cost bonds that cities issued and whose rates reset in daily or weekly auctions. Houston issued $1.8 billion worth of VRDNs in May 2008, but when the auctions froze up, it found itself paying 15 percent interest rates instead of the much lower money-market-type rates it had anticipated.

VRDNs are a $479 billion market and when the auctions failed, the banks that helped the cities issue the securities had to guarantee them. To do so, many began charging the cities much higher rates than they were used to getting through the open auctions. In fact, with the guaranteeing banks have taken on $1.3 trillion in losses in the last 18 months, some are charging 10 times higher rates. So why should you care?

Well, if you live in a city that's used VRDNs, that city is likely to be cutting back on services and firing employees. That's because the city must pay far more than it had budgeted to cover interest expense. And with tax revenues plunging, the only way to operate with a balanced budget is to cut cut cut.

Add it to the list.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.

Read Full Story