VideoOn February 7, 2008, Joseph Broce, assistant treasurer of Ashland Corp., authorized Oppenheimer Co. to buy $15 million worth of auction-rate securities (ARS) on Ashland's behalf. The money was from a 2005 asset sale that netted the chemical company more than $1 billion in cash. Ashland wanted to keep the money close at hand as it trolled for an acquisition in the specialty chemical space.
Six days later, Goldman Sachs put a serious crimp in Ashland's plans. The investment bank discontinued the practice of propping up auction-rate debt that it underwrote, refusing to buy inventory in any auction when investor bids were insufficient. A day later, other broker-dealers — Lehman Brothers, Citigroup, Merrill Lynch, and UBS among them — followed suit. Eighty percent of the auctions held on February 13 failed, offering a glimpse of the chaos that would erupt on Wall Street seven months later.
Although auction-rate securities have received scant media attention since then, they have not returned to health. In fact, the market for them remains decidedly frozen. Ashland was stuck with a total of $194 million of the illiquid securities, and its real losses so far total $32 million. The company is far from alone. The collapse of the asset-backed securities (ABS) market left many finance departments embarrassed and enraged. Collectively, nonfinancial public companies have $24 billion (par value) worth of ARS on their books, according to Pluris Valuation Advisors. (No CFO responded to our requests for an interview. For a list of corporations with large holdings, see "Hard to Hold," below.)
The ABS debacle has spurred lawsuits (Ashland, for one, is suing Oppenheimer), Securities and Exchange Commission investigations, and scathing accusations by state attorneys general that broker-dealers hid market risks from investors. It has also raised the question of whether treasury departments should have avoided the market's fall, and whether they will avoid repeating their mistakes with other investments.
Auction-rate securities are long-term bonds and preferred stocks that resemble short-term instruments because their interest rates are reset periodically — usually every 7, 28, or 35 days — by a modified Dutch auction process. Because investors could (at least in theory) sell or buy the securities at short intervals, ARS were long regarded as cash equivalents. Investors also thought their principal was safe, because ARS were backed by government-guaranteed student loans and municipalities and wore a triple-A credit rating. Few auctions had failed since the securities debuted in 1984.
"This was a no-brainer type of investment — you buy it, it pays every week, you roll it over," says Jeff Wallace, managing partner of Greenwich Treasury Advisors. "No one ever thought, 'What would happen if liquidity were to go away?'"
But when the subprime-mortgage crisis weakened the credit stance of bond insurers like Ambac and MBIA, concerns arose about the credit quality of ARS with insurance "wrappers." Banks then started having balance-sheet problems of their own and stopped acting as bidders of last resort — a practice that had been, as it turned out, more common than investors thought. Suddenly, companies couldn't liquidate positions. The first auction failure occurred in early September 2007, according to a Purdue University study. In December 2007, 21 auctions failed; in January 2008, 158 failed; and in the first week of February 2008, 104 did so.
A Dearth of Diligence
Experts say that CFOs and treasurers should have seen signs of trouble (see "Dead Canaries" at the end of this article). Indeed, even if ARS investors had done nothing more than simply follow sound cash-management practices, the damage would have been far less.
For example, nearly half of organizations polled by the Association for Financial Professionals (AFP) in 2008 had policies limiting their investments in ARS to 25% of the portfolio, yet one in four allowed ARS investments to reach 50% or more. "You can't do anything about greed [finance departments chasing yield], but some clients had 100% of their excess cash invested in ARS," says Wallace. "That violates a cardinal rule of investment: diversify asset classes."
Investors were also not adequately compensated for the risk that auctions could fail, notes Adam Dean, president of SVB Asset Management. Average premiums over money-market funds ranged from just 15 to 20 basis points.
The sheer lack of information on auction-rate holdings also should have been a warning sign. Some brokers didn't even provide a prospectus until after auctions concluded. Data on monthly collateral performance was not available, unlike with other asset-backed securities, says Lance Pan, director of research for Capital Advisors Group. Some finance executives whose firms bought ARS relied on a monthly statement detailing the name of the security and the investment's size and performance, and a letter declaring that the investments were in line with corporate policy. "That level of rigor doesn't fly anymore," says Courtlandt Gates, CEO of Clearwater Analytics, a portfolio reporting tool maker.
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