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Treasury departments are still paying a price for auction-rate securities.
Vincent Ryan, CFO Magazine
July 15, 2009
On 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.
Paul LaRock, a principal at Treasury Strategies, says that many finance executives just didn't understand that the risk profile of ARS had changed. Entering 2008, there was not as much corporate money to soak up the supply. (According to the AFP survey, the number of companies permitting cash investments in ARS declined to 18% in 2008, from 33% a year earlier.) What's more, the weakening of monoline insurance companies meant greater risk from an issuer defaulting.
ARS investors basically have four options, say experts. One, they may decide simply to hold on to the securities. Says Gates, "In some cases they are money-good and quite attractive at the penalty rate" that the securities reset to after a failed auction.
A second option is to "put" ARS back to the broker-dealer, under agreements with federal regulators. In the deals banks have made with regulators, retail investors were paid first. Citigroup, JPMorgan Chase, and Morgan Stanley have until the end of this year to settle with institutions; Wachovia (now part of Wells Fargo) has until the end of June. UBS does not have to start liquidating institutional holdings until June 30, 2010.
A third option is to offload ARS in the secondary market, albeit sometimes at a deep discount. While some hedge funds have emerged as buyers of ARS in the secondary market, they are paying well below par. In early June, prices for student-loan-backed ARS ranged from 60 cents to 80 cents on the dollar, says Chris Chakford, a managing director at SecondMarket.
Finally, ARS holders can wait for the issuer to refinance. Because the penalty rates on municipal ARS were so high, more than half of the securities have been refinanced, says Chakford. The outstanding municipal ARS have either very low maximum rates or weak issuers. But the House Financial Services Committee is discussing temporary liquidity facilities or a federal guarantee that would enable municipal issuers to restructure the debt. As for student-loan-backed ARS, few issuers are refinancing, Chakford says, because the term ABS market is dislocated and fixed-rate financing is prohibitively expensive.
Meanwhile, the Municipal Securities Rulemaking Board is trying to make the market transparent. Broker-dealers now have to provide the MSRB's Electronic Municipal Market Access system with information on interest rates, date and time of auction, and whether the auction succeeded or failed. (As of early June, three out of every four auctions were still failing.)
The MSRB has also drafted a proposal, out for comment, that would require dealers to submit disclosure documents, which include information on liquidity provisions as well as bidding information detailing whether or not the dealer bid for its own account. "I would view that [last item] as a critical piece of information," says Justin Pica, director of uniform practice policy at the MSRB.
Information was in short supply for investors in auction-rate debt. But without governance improvements, firms could easily wind up in this spot again. "Right now, many audit committees are spending a lot of time talking about investments that are under water," Pan says. "We think such discussions need to be a regular item, so companies don't let their guard down."
Vincent Ryan is a senior editor at CFO.
ARS investors missed key signs of impending trouble.
Plenty of "canaries in the coal mine" foretold the dislocation of the auction-rate securities (ARS) market, says Courtlandt Gates, CEO of Clearwater Analytics, makers of a portfolio reporting tool. As early as 2005, the Big Four auditors told accounting clients that auction rates could no longer be classified as "cash equivalents." (The average ARS had a maturity of 24 years.) In 2006, the Securities and Exchange Commission penalized 15 securities dealers in the ARS market for violating securities laws, including bidding for a firm's proprietary account without disclosing it.
And five months prior to the February 2008 failures, ARS yields spiked relative to yields in variable-rate demand notes, which are similar to ARS but differ in one critical respect: they give the investor the unqualified option to sell the bond back. By contrast, ARS lacked a "put" — an agreement that lets investors sell them at face value at any time, says Lance Pan, director of research for Capital Advisors Group. While many finance departments now accuse underwriters of having implied or even explicitly stated that they would prevent auctions from failing, contractually they had no obligation to.
"The term [dealers] used was 'soft put,'" says Pan. "It means you have to have new investors to take your position in order to get out at par. If you don't have equilibrium of buyers and sellers, you can't get out" — as a number of companies now trapped in the ARS mine shaft learned all too late. — V.R.