Long-term auction rate problems could ripple

By Emily Chasan

NEW YORK (Reuters) - Prolonged troubles in the auction-rate securities market, dominated by municipal issuers such as states, counties and cities, could weigh on local governments and ripple throughout the economy, a leading U.S. economist said on Wednesday.

Towns and cities which used such debt for financing may find themselves struggling to pay higher interest rates to debt holders, said Mark Zandi, chief economist and co-founder of Moody's Economy.com, at the Reuters Housing Summit in New York.

"If it lasts another week, two, or three, it's costly" for municipalities, Zandi said. "But if it goes on for another couple two or three months it begins to affect plans for infrastructure spending, for operations."

Auction rate securities are a type of long-term floating-rate debt whose interest rates reset periodically through a "dutch auction." But demand for the securities has dropped off a cliff in the last few weeks, and auctions have been failing to attract bidders.

For investors a failed auction is a problem because cash they thought could be readily accessed becomes tied up indefinitely. But for municipalities, it can be a graver issue because they have to pay sharply higher interest rates to the security holder.

"For state and local governments this is going to affect their planning for fiscal '09 and fiscal '10 and that will go out through the end of the decade," Zandi said.

Some municipalities are considering switching the debt to fixed-rate paper or variable rate demand notes, but that could also be expensive.

To make matters worse, Zandi said, the auction rate troubles are coming at one of the most difficult times for local governments as worries about an economic recession and high home foreclosure rates are beginning to eat up their tax base.

"They've got other problems to grapple with. Property tax revenue is starting to be affected by the housing downturn," Zandi said.

(For summit blog: summitnotebook.reuters.com/)

(Reporting by Emily Chasan, editing by Richard Chang)