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determined by buyers. If the auction fails, the interest rate goes up, usually to a rate specified in the documents. In some cases, the rate for unsold bonds rises as high as 20 percent (rates vary by bond), and the investor is left holding the old bonds. Auctions have rarely failed, so the market was in a panic. Some ARS were a bargain, but that meant municipalities were paying higher interest costs solely due to the confusion. For municipalities, that means taxpayers may pay higher taxes. Municipalities struggle to find a way to refinance into reasonable fixed rate debt in the dicey market, and as of June 2008, only 25 percent have refinanced. Local tax rates may increase to cover their problems.

Banks and investment banks are hurting from lack of ready cash (liquidity) and would not buy back bonds since everyone’s confidence is so shaken that it is hard for the banks to trade them. Many investors were told by their bankers that the bank would always buy the bonds if an auction failed. Many investors were told these bonds were as safe as T-bills. Investors felt scammed. Some investors did not even see a prospectus until the auctions failed. Cash management accounts across the globe ranging from large corporate clients such as Google to small condominium associations could not sell their ARS.That may not be a crisis for Google, but customers like some condominium associations could not pay their bills and have to ask condo owners for more money.

Even pension funds invested in these “AAA money market” securities. These assets are “guaranteed,” but many bond insurers are in trouble, so their “guarantee” is not worth anything. In some cases the underlying assets seem sound (so the “guarantee” does not matter), but in other cases there is a genuine risk of principal loss and the guarantee people depended on is worthless because “sophisticated” bond insurers guaranteed bad products manufactured by investment banks. Some but not all of the top underwriters (sellers) of municipal auction-rate securities included players in the subprime market: Citigroup, UBS, Morgan Stanley, Goldman Sachs, Bear Stearns, Merrill Lynch, Wachovia, Bank of America, JPMorgan Chase, Royal Bank of Canada, and Lehman Brothers, but few of the underwriters have clean hands when it comes to this new problem. Class action suits abounded. Banks and investment banks had undisclosed conflicts of interest with their retail customers, and seemed to pass on their liquidity problems to their customers.345 Many banks paid fines to settle claims with U.S. regulators and agreed to buy back ARS at full price (par) from retail clients and small businesses.67 The buy-back was unprecedented, but it did not include all customers. Larger customers are deemed to be sophisticated enough to know what they are doing, whether or not that is actually true.Those customers are usually left to work out their disputes themselves.8

Many of the small accounts are handled by the “retail” side of banks and investment banks. Small investors thought their banks had a fiduciary responsibility to them.Yet, it now seems as if finance has become a game of “every man for himself.” In The Spanish Prisoner, Steve Martin plays a confidence man who advises:“Always do business as if the other person is trying to screw you because most likely they are, and if they are not, you can be pleasantly surprised.” In the current financial environment, it has come to that, because regulators failed to do their jobs.

A certain and stable AAA rating is extremely valuable to any bond insurer. Investors pay for the guarantee believing it means uninterrupted cash flows and that belief means market liquidity. Even if interest rates in general rise and prices drop somewhat, the fact that one can count on cash flows makes reliable AAA bonds easier to price and trade. But if ratings are in doubt, the market freezes.

In December 2007, seven bond insurers were rated AAA. Standard & Poor’s said underwriting quality for several of the bond insurers was high, but that was not true. The underwriting standards were