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CDOs All Over Again


If we ignore even recent history, we deserve the doom of repetition.


The saga of the market for Auction Rate Securities, or ARS, has taken an ominous turn. Professor Sedacca has been all over the story since its early, pre-headline days, and this morning The Wall Street Journal reports brokerages and the debt issuers they represent are pleading with the SEC for a respite from their woes.

The securities industry and Financial Markets Association, a Wall Street trade group (read: lobbyist), and a group of 14 hospitals have petitioned the SEC to temporarily lift a ban on issuers buying their own debt. If this sounds strange, it is.

The market for ARS froze up a couple weeks ago. Since then, municipalities reliant on such short-term funding have been forced to pay the usurious rates these securities carry if no one bids for them at auction. Some analysts scoffed at concerns over the severity of the issue, calling the problems temporary, since issuers like the New Jersey Port Authority could just refinance the debt and pay off the higher coupon notes.

This solution has been difficult to execute thanks in part to dysfunctional credit markets. The latest plea reeks of desperation, particularly since Street firms like Lehman Brothers (LEH) and Goldman Sachs (GS) are the ones arranging these auctions. That these supposedly well-capitalized firms can't absorb the relatively small notional value of these securities is indicative of just how cash-strapped they are.

It's reminiscent of another time firms bought their own debt when markets wouldn't go near it. Think back to mid-2007, pre-credit crunch, when they issued ingenious structured credit products called collateralized debt obligations. The market for these obscure financial instruments dried up, but issuers, convinced the problems were only temporary, snapped up their own unwanted debt. The riskiest slices of CDOs ended up on the balance sheets of underwriters, most notably Merrill Lynch (MER) and Citigroup (C), who wrongly assumed they could hold the assets for a few months until the market came back.

The market didn't come back. And the rest, as they say, is history.

There continues to be an assumption on the part of market participants that credit conditions will return to normal as a function of time. While grounded in historical precedent, fundamentals continue to deteriorate and situations keep going from bad to worse. Thus far, it hasn't paid to wait for things to get better. It's unreasonable to think this strategy is about to start paying off.

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