Something New From The Auction Rate Security Crisis: Student Loans That Pay Almost Nothing

We have all heard about "municipals" (which can include quasi-government entities) pay extremely high interest rates on their auction rate securities due to the collapse of the ARS (auction rate security) market. Well, now we have the truly bizarre opposite scenario of student loans that pay close to zero percent interest (on somewhat risky loans). Bloomberg has a good story on one of the side-effects of the collapse of the ARS market.

(source: Auction-Bond Flops Stick Student-Loan Holders With 0%, By Michael B. Marois and Jeremy R. Cooke. April 25, 2008. Bloomberg)

More than $9 billion of auction- rate bonds sold by student-loan agencies in U.S. states from Pennsylvania to Utah have trapped investors in debt that's not paying interest...

The bonds pay nothing because of a formula designed to ensure that borrowers don't pay more interest on their debt than they receive from their student-loan clients. The mechanism kicked in as rates climbed above 10 percent since February, when dealers stopped buying securities that went unsold at auctions...

A Utah State Board of Regents bond with interest that changes every 35 days jumped to 16.58 percent on March 5, up from 3.8 percent in January. The same bond's interest then dropped to 0 percent on April 9, when the provision took effect.

Rates on $97 million of bonds sold by the Pennsylvania lending agency more than doubled to 9.85 percent on March 7 before falling to 0 percent this month.


Fortunately, it seems like these zero or near-zero rates are for the short term and will change.

As I have said before, I think the ARS market is likely to die off. The collapse of the market is partly due to the credit squeeze faced by the investment banks, and partly due to the loss of investor confidence in monoline insured bonds (making investors flee almost any bond where bond insurance may be involved). I don't work in the industry or understand the details but the whole notion of using an auction to determine rates seems really dumb. One of the first things investors will learn when they start investing in anything is that irrational things happen quite frequently. Classic cases will involve investors paying ridiculous amount of money for something of dubious quality, while conversely not willing to pay anything for something valuable. Such events will make ad-hoc systems like auctions fail easily so I'm not sure why this system became popular.

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