Tough Math on the Hilltop

By Steven Pearlstein
Friday, February 15, 2008

As a good Jesuit, Bishop John Carroll, the founder of Georgetown University, would probably not have thought to look for God in the steepness of the yield curve.

But in their zeal to shave a couple of hundred basis points off their interest rates by borrowing short for long-term projects, Carroll's successors find themselves caught up in the ever-widening crisis on global credit markets.

In simpler times, universities like Georgetown would have issued 20- or 30-year bonds to finance long-term projects such as building classrooms and equipping laboratories. The bonds would be issued through the District of Columbia, making interest payments tax-free to investors. To guarantee that the investors would receive their principal and interest even if the university ran into financial difficulty, Georgetown would typically purchase insurance from one of a handful bond insurers, effectively riding on the insurer's AAA credit rating.

By 1999, Wall Street's financial engineers were knocking on Georgetown's doors with a new product that they promised would lower the school's borrowing costs. Called an auction-rate security, this bond effectively allowed the university to borrow large amounts of money over long periods while paying lower short-term rates that reset on the basis of auctions held every week or every month.

Like the fixed-rate bonds, the auction-rate securities were insured and tax-exempt. And if, at any of those auctions, the number of investors wanting to sell their Georgetown bonds exceeded the number wanting to buy or renew them, there was an unwritten understanding that the Wall Street investment house serving as broker for the auction would step in to make up the difference, at least until the next auction.

The new securities proved very popular, not only with Georgetown, which lowered its long-term borrowing costs from 5 to 3 percent, but with a variety of borrowers, including cities, towns and public agencies. The securities were also popular with wealthy investors and corporate treasurers, who liked the ease with which they could be bought and sold and the higher yields than they could get on short-term Treasurys and other AAA paper.

No wonder then that by the end of 2006, the market in auction-rate securities had grown to $350 billion, including $500 million from Georgetown.

By now, you've probably figured out what comes next. For in many ways, Georgetown is not unlike those homeowners who figured they could borrow more money by financing their long-term housing needs with one-year adjustable-rate mortgages. And just like many homeowners, Georgetown officials weren't worried about the market turning against them because they knew they could always refinance into a fixed-rate, 30-year loan.

Beginning last summer, as those adjustable rates began to rise and as credit markets tightened, investors began to worry. They questioned whether the bond insurers would be able to make good on their guarantees. Then, on Jan. 22, a number of regularly scheduled auctions had to be canceled because sellers severely outnumbered buyers. Among the "failed" auctions was one for $100 million in Georgetown securities.

As with much that's gone wrong in credit markets, the problems with auction-rate securities can be traced to the subprime fiasco. The concern about the insurers was prompted by the mountain of losses they faced from the guarantees they sold on mortgage-backed securities -- losses that jeopardized the AAA rating that they had conferred on the Georgetown securities. To make matter worse, the Wall Street firms that had underwritten university securities -- Lehman Brothers, Goldman Sachs and Morgan Stanley -- are in no position to serve as buyers of last resort.

For Georgetown, the failed auction posed no immediate financial threat. Under the terms of the offering, investors were required to hold on to the securities until the next scheduled auction, with the new interest rate set at 6.6 percent, a rate calculated off the benchmark overnight bank lending rate known as Libor. Because nothing has fundamentally changed in Georgetown's ability to keep current on its loan payments, the school should be able to replace its auction-rate securities with long-term financing, albeit at a higher interest rate. But others have not been so lucky. The Port Authority of New York and New Jersey had its interest rate jump from 4.2 percent to 20 percent as a result of a failed auction. In Pennsylvania, a state agency that makes loans to college students said it won't be making any new loans until it finds a new source of financing.

On Capitol Hill yesterday, the Treasury secretary and Federal Reserve chairman tried to calm concerns about the auction-rate market, suggesting that it was just part of the healthy repricing of risk. They also expressed hope for a solution to the bond insurers' crisis, which continues to roil global stock and bond markets.

Don't be fooled, these guys are plenty nervous. They've already been surprised by how easily the financial virus has spread from one market to another and how quickly it has dragged down the rest of the economy. While it's true that the problems of any one of the troubled markets can probably be worked out without too much damage to the financial system, nobody knows what will happen when so many markets are trying at the same time to make big and painful adjustments.

What can government do to get a handle on all this and make it go away? In truth, probably not much more than it's doing, short of some sort of bailout of banks, bond insurers, homeowners or investors. In the end, it may come to that. But at this point, those are options just about everyone is hoping to avoid.

Steven Pearlstein can be reached at

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