Transit, high finance, and second guessing markets

Whenever business decisions go sour, people start looking for people to blame. Few times do they look in the mirror and cast blame upon themselves. And even more rarely do we sometimes simply admit we screwed up. Something like this is unfolding over the problems of transit agency finance, and the New York Times recently had an interesting article tracking the bond market woes of Citigroup and New York’s Metropolitan Transit Authority. At issue is the decision by Citigroup, upon advice from Goldman Sachs, to issue bond’s for the MTA in the esoteric bond market. The problem is, analysts inside Citigroup had begun to voice doubt on the efficacy of using the bond auction market as early as the summer of 2007.

In August 2007, an official at Citigroup sent an e-mail message to a colleague warning of trouble in an obscure corner of the financial world: the $330 billion market for auction-rate securities. “There are definitely cracks forming in the market,” read the e-mail message, which is cited in a complaint filed last month by the Securities and Exchange Commission against a Citigroup subsidiary, Citigroup Global Markets. “Inventories are starting to creep higher in the market and failed auction frequency is at an all-time high.”

A “red flag” became a prescient predicator of the collapse of the bond market, and MTA got caught in the middle.

But that did not stop the bank from peddling the securities to investors and working with government agencies ââ?¬â?? including the Metropolitan Transportation Authority, which runs New York’s sprawling subway, bus and commuter rail system ââ?¬â?? to bring more bonds into the already stressed market. With Citigroup Global Markets as one of its underwriters, the authority issued $430 million of auction-rate bonds on Nov. 7, 2007. Almost immediately the deal soured. Interest rates on the bonds, set in weekly auctions, began to climb, to 4 percent from about 3 percent, and finally, by February, to 8 percent. By then, the entire auction-rate market had collapsed as panicked investors worried that they could not get access to their money.

As a result, the MTA started paying millions more in interest it wouldn’t have had to if it had gone through normal bond markets. Citigroup and Goldman Sachs still made hundreds of thousands of dollars off the deal, even though they went sour. Understandably, the MTA believes that Citigroup should have had a better handle on how the auction market was functioning. However, auctions are inherently risky. While past behavior is often a good predictor of the future, when markets are undergoing significant transitions, auctions no longer behave in historically consistent patterns. Perhaps Citigroup and Goldman Sachs should have had a better handle on the fundamentals of the auction markets. On the other hand, we need to be careful about second guessing decisions made in the midst of very terbulent and uncertain times. Raising a red flag is not the same thing as foretelling the future, and we need to be wary of making policy about financial regulation simply by looking in the rear view mirror.