A Crisis of Faith

By PAUL KRUGMAN
Published: February 15, 2008

Adecade ago, during the last global financial crisis, the word oneveryone's lips was “contagion.” Troubles that began in a far-awaycountry of which most people knew nothing (Thailand) eventually spreadto much bigger countries with no obvious connection to Southeast Asia,like Russia and Brazil.
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Today, we'rewitnessing another kind of contagion, not so much across countries asacross markets. Troubles that began a little over a year ago in anobscure corner of the financial system, BBB-minussubprime-mortgage-backed securities, have spread to corporate bonds,auto loans, credit cards and now — the latest casualty — student loans.

Indeed,this week the state of Michigan suspended a major student-loan programbecause of the sudden collapse of another $300 billion market you'venever heard of, the market for auction-rate securities.

Why hasa crisis that began with loans to a limited group of home buyers endedup disrupting so much of the financial system? Because, ultimately,it's more than a subprime crisis; indeed, it's more than a housingcrisis. It's a crisis of faith.

I know that sounds dramatic. But, let me talk about what just happened to auction-rate securities.

Likemany of the financial innovations that are now being called intoquestion, auction-rate securities are complicated deals that seemed tooffer something for nothing.

They seemed to offer the borrowers— typically local governments or quasi-governmental agencies, like thePort Authority of New York and New Jersey and the Michigan HigherEducation Student Loan Authority — a way to borrow long term withoutpaying the relatively high interest rates investors usually demand onlong-term loans.

At the same time, they seemed to offerinvestors an asset that was as good as cash — readily availablewhenever needed — but paid higher interest rates than bank deposits.

The operative word in all of this, of course, is “seemed.”

Auction-ratesecurities seemed as good as cash because they involve regular, well,auctions, held as often as once a week, in which investors wanting outsell their positions to investors wanting in. In principle, it wasalways possible for auctions to fail for lack of enough willing buyers— but that wasn't ever supposed to happen.

Meanwhile, thesesecurities seemed like a good deal for borrowers despite the fact thatthey contain a penalty clause: if an auction fails, the interest ratethe borrower pays jumps up. (The Port Authority, which had a failedauction last week, just saw the interest rate it pays leap from 4.3percent to 20 percent.) You see, there weren't ever supposed to befailed auctions, so the penalties weren't supposed to be relevant.

Now,what wasn't ever supposed to happen has. In the last few weeks, aseries of auctions have failed, leaving investors who thought they hadready access to their cash stuck, even as borrowers find themselvespaying penalty rates.

The collapse of the auction-rate securitymarket doesn't reflect newly discovered problems with the borrowers:the Port Authority is as financially sound today as it was a month ago.Instead, it's contagion from the broader credit crisis.

Onechannel of contagion involves monoline bond insurers, the specializedinsurance companies that are supposed to guarantee debt. Thesecompanies insured buyers of local government debt against losses — butthey also guaranteed a lot of subprime-related investments, which makeseveryone wonder whether they'll actually have the money to compensatelosers in other markets.

More important, however, is the way theever-widening financial crisis has shaken investors' faith in the wholesystem. People no longer trust assurances that fancy financialinstruments will function the way they're supposed to — after all, theyknow what happened to people who thought their subprime-backedsecurities were safe, AAA-rated investments. Why, then, should theybelieve that auction-rate securities are as good as cash?

Andloss of trust can be a self-fulfilling prophecy. Now that new investorswon't buy auction-rate securities because they no longer believe thatthey're as good as cash, those securities become a much worseinvestment.

Needless to say, all of this is bad for the economy.I like to think of what's happening as a sort of minor-key reprise ofthe banking crisis that swept America in 1930 and 1931. Frustratedinvestors who can't get their money out of auction-rate securitiesaren't as photogenic as angry mobs milling outside closed banks, butthe principle is the same. And so are the effects: would-be borrowerscan't get credit, and the economy suffers.

One simple measure ofthe seriousness of the credit problem is this: although the FederalReserve has sharply cut the interest rate it controls over the past fewweeks, the borrowing costs facing many companies and households haveactually gone up.

And the financial contagion is still spreading. What market is next?