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Stadium finance and the auction-rate market

The last month or so has seen some dramatic changes in the auction-rate bond market. This is a market in which some recent stadium and arena financing has been acquired by state and local governments, Louisiana and Indianapolis being two examples. What has happened is that average rates of interest have jumped enormously.

Bloomberg.com cites the Securities Industry and Financial Markets Association, "Auction rates jumped to 6.73 percent this month from an average 3.94 percent in the previous year". Some reports I read indicated rates on these bonds jumped as high as 20%. Bonds in this market are of long term maturity, but the interest rates are determined in the short term via an auction mechanism.

Consider an auction in which sellers offer items for sale that buyers don't bid on. The items obviously won't sell and the auction fails. Suppose that the seller can make the unsold item more attractive and try again. Then the sale may go through, but obviously the seller does not do as well as if the sales had proceeded without sweetening the deal. Alternatively, some buyers might see the auction is failing and rush in to buy up the unsold items, in effect guaranteeing the sellers can sell their items. In the auction-rate bond market, this has been the history of the market. If sales were not proceeding, large institutional investors came to the rescue. Now they are not doing so. The drop in demand, it seems, is partially a consequence of the sub-prime mortgage mess, but also related to a change in the way such investments are recorded on firm balance sheets and cash-flow statements following a change recommended by the Financial Accounting Standards Board. The consequence is that sellers, the state and local governments, have effectively had to sweeten the pot to get buyers, which has meant paying higher interest rates.

What this means, therefore, is that bonds floated on this market by state and local governments to finance stadiums saw their interest rates rise substantially. Think of it this way, if the benefits of a stadium were about equal to the interest payments the financing required when interest rates were 3 or 4 percent, then those benefits are well-below the interest payments now that rates are over 6 percent.

The auction-rate market had been a pretty stable one, so in one regard it is hard to fault state and local governments for failing to predict a highly unusual event. On the other hand, there were rumblings of bid-rigging in the last few years and there is always risk that rates will rise with a variable rate instrument. The FASB recommendation came down in March of 2007, so there has been some advanced warning of likely changes in this market that made state and local government debt managers more cautious.

A 2004 California government document on Auction-rate debt concluded with this:

ARS, like other variable rate debt instruments, require a greater commitment of time and expertise by staff managing the program.

I hope the states that used this debt to finance their stadiums followed this advice.