The good news: Consumers and homeowners should not feel ashamed because they were misled by Wall Street. Some of the most brilliant financial minds in the world were also sold some risky products by Wall Street.

Auction rate securities (ARS) have been around since 1984 but at the turn of this century, Wall Street began aggressively to push auction rate securities to bond issuers (Municipalities, States, Counties, Universities, Housing Finance Agencies, quasi-governmental agencies and others). Auction rate bonds are similar to Adjustable Rate Mortgages (ARM) in that they can finance long-term debt with an adjustable product pegged to some index. Another similarity is the introductory or teaser rate at the beginning which makes the ARM attractive to homeowners and the ARS appealing to municipal borrowers.

A fairly large number of homeowners in the subprime industry were sold what is referred to as the 2/28 ARM. After the first 2 years, the mortgage rate will adjust at a certain interval (6 mos., l, 2, 3, 5 yrs. etc) for the next 28 years. Unlike an ARM, auction rate securities adjust every 7, 28 or 35 days. Depending on the interval (7,28,35) the bonds will be offered at an auction held by an intermediary such as Goldman Sachs, Citigroup or UBS. In the past, bond dealers have stepped in with their capital when an auction failed, which was rare.

The bad news: Your roads will not get repaired, student loan options have decreased, there will be no new wing at the hospital and City/County services will be drastically reduced.

The Port Authority of NY/NJ, Georgetown University and Palm Beach County Schools represent a few of those entities which issued bonds for long-term projects. These bonds were insured by one of the bond insurers (Ambac, MBIA, FGIC, etc., see last week's article for a brief description on bond insurers). The bond insurers gave a guarantee to investors that principal on these bonds would be paid. The bond insurers were backed with an AAA rating from Fitch, Standard & Poors and Moody's. The bond insurers also guaranteed corporate bonds that were collateralized with subprime mortgages. The insurers took a beating on the corporate bonds similar to what Ali gave Quarry. The insurers became undercapitalized and made several attempts to raise capital to prevent a rating downgrade. The three rating agencies have them under review today and alternatives are being explored by NY State, Berkshire Hathaway and federal agencies.

Meanwhile those municipal borrowers (schools, cities, counties etc.) discovered in January, 2008, there were few investors willing to purchase their bonds. When there are not enough orders for the bonds, it is called a failed auction. Since 1984 through December, 2007, there were only 44 failed auctions. On February 20, 2008, there were 395 or 62% failed auctions. On February 13, 2008 over 80% of the auctions failed. Investors are skittish about the capitalization of the bond insurers. In the past, on that rare occasion when an auction failed, the bond dealer would commit to buying the bonds. The exposure to the subprime market, concern about the rating of the insurers, and recent writedowns, has made dealers cautious about participating in a buy-back or secondary-market position.

The municipal borrowers have few takers for their auction rate securities and now the rate will reset to the maximum in their contract, an alarming position when one considers the amount of money involved in the issues. Many of the borrowers are attempting to convert to a fixed rate to stop the bleeding. Palm Beach County Schools' bond issue of $116 million failed and the weekly payment went from $107,000 in December when the rate was approximately 4% to $220,000 recently when converted to the fix rate of 9.75%. The penalty rate in their contract is 15% so the conversion was timely. The City University of NY (CUNY) saw its weekly payment on $980 million in auction rate securities increase from $683,000 to nearly $1.1 million. There are probably thousands more that are similarly situated.

Last week many cities, hospitals, schools and other issuers scrambled to convert their auction rate to a fix rate. In the absence of the conversion or the bond insurers becoming well capitalized, the municipal borrowers will, more likely than not, have their credit rating downgraded or default on their obligation. The best case scenario is the borrower will sell off the auction rate bonds, convert to a fixed rate and increase your water, sewer, utility, taxes and any other bill they can collect from you so they can pay the debt Wall Street put on them. And you think homeowners were the only ones hoodwinked. Next, we will discuss the subprime debacle.

BlackCommentator.com Guest Commentator, Lloyd Wynn was a consultant in the secondary market. Lloyd is the author of Residential Real Estate Finance:  From Application Through Settlement. Click here to contact Lloyd Wynn.

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