Paul Krugman Feb 15

..., this week the state of Michigan suspended a major student-loan program because of the sudden collapse of another $300 billion market you’ve never heard of, the market for auction-rate securities.

Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, it’s more than a subprime crisis; indeed, it’s more than a housing crisis. It’s a crisis of faith.

I know that sounds dramatic. But, let me talk about what just happened to auction-rate securities.

Like many of the financial innovations that are now being called into question, auction-rate securities are complicated deals that seemed to offer something for nothing.

They seemed to offer the borrowers — typically local governments or quasi-governmental agencies, like the Port Authority of New York and New Jersey and the Michigan Higher Education Student Loan Authority — a way to borrow long term without paying the relatively high interest rates investors usually demand on long-term loans.

At the same time, they seemed to offer investors an asset that was as good as cash — readily available whenever needed — but paid higher interest rates than bank deposits.

The operative word in all of this, of course, is “seemed.”

Auction-rate securities seemed as good as cash because they involve regular, well, auctions, held as often as once a week, in which investors wanting out sell their positions to investors wanting in. In principle, it was always possible for auctions to fail for lack of enough willing buyers — but that wasn’t ever supposed to happen.

Meanwhile, these securities seemed like a good deal for borrowers despite the fact that they contain a penalty clause: if an auction fails, the interest rate the borrower pays jumps up. (The Port Authority, which had a failed auction last week, just saw the interest rate it pays leap from 4.3 percent to 20 percent.) You see, there weren’t ever supposed to be failed auctions, so the penalties weren’t supposed to be relevant.