The Wall Street Journal [subscription required] reports that we need to learn about another acronym thanks to Wall Street's financial engineers whose fragile financial instruments keep blowing up. Today's explosion is in variable-rate demand notes (VRDN) -- which let issuers borrow for long periods -- but at short-term interest rates. Like auction-rate securities (ARSs), interest payments adjust on a weekly or even daily basis. The difference is that securities firms sell VRDNs at whatever interest rate meets the market's demand.
This is a huge market -- $500 billion, or 52% bigger than the $330 billion ARS market. I've been asked what I thought the next shoe to drop would be after the ARS blowup. And I'm happy to report that I said I had no idea. I had never heard of VRDNs before this morning. But the market for VRDNs is freezing up -- just like the ARS market.
Specifically, some VRDN auctions failed -- hitting some municipalities with sharply higher interest because dealers of the debt are having trouble selling it. Last week, rates on $300 million of California's variable-rate demand notes rose to 8.25% from 2% the previous week. As with the ARS market, this freeze up will lead to more unpleasant surprises for holders of VRDNs -- like the one I posted on yesterday in which a journalist who thought his ARS investment was as liquid as a money market fund discovered his funds were frozen.
The worst part for the investing public is that we have no way of knowing where the next explosion will take place. It looks like some financial terrorists are winning.Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
3-09-2008 @ 11:12AM
Ken said...
I'd like to learn what the downside potential is for a VDRN and how this compares to other bond investments. I think I understand that VDRNs may, in this market, suffer from liquidity issues, however presumably the underlying security has its own intrinsic value and the obligation of the municipality is as good as the credit worthiness of the municipality, right?
I presume that you may not get paid today, if there is a liquidity crisis for these securities, but ultmately the bond will be liquid at some future date and presumably in a more normal market the bond holder will not be hurt, right?
As someone who has 'parked cash' in VDRNs, and never had a problem, I'd like to learn what some of the downside scenarios are for these types of securities.
3-28-2008 @ 5:00PM
Analyst said...
"Specifically, some VRDN auctions failed -- hitting some municipalities with sharply higher interest because dealers of the debt are having trouble selling it. "
No, no, no. VRDNs are NOT an auction product. The higher rates are due to general liquidity crunch concerns, as to wether banks have the balance sheet to make good on their liquidity puts. There have been no failed aucitons, because VRDNs are not sold by auction.
Please correct your commentary, but thank you for the input.